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Advanced
Financial
Accounting
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ADVANCED FINANCIAL ACCOUNTING, TWELFTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2019 by McGraw-Hill Education. All
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Library of Congress Cataloging-in-Publication Data
Names: Christensen, Theodore E., author. | Cottrell, David M., author. |
Budd, Cassy, author.
Title: Advanced financial accounting / Theodore E. Christensen, University of
Georgia, David M. Cottrell, Brigham Young University, Cassy JH Budd,
Brigham Young University.
Description: Twelfth edition. | New York, NY : McGraw-Hill Education, [2019]
Identifiers: LCCN 2018007456 | ISBN 9781259916977 (alk. paper)
Subjects: LCSH: Accounting.
Classification: LCC HF5636 .B348 2019 | DDC 657/.046—dc23
LC record available at https://lccn.loc.gov/2018007456
The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an
endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the
information presented at these sites.
mheducation.com/highered
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About the Authors
Courtesy Brigham Young University/Photo by Alison Fidel
Theodore E. Christensen
Ted Christensen has been a faculty member at the University of Georgia since 2015. Prior to coming to UGA, he was on the faculty at Brigham Young
University for 15 years and Case Western Reserve University for five years. He received a BS degree in accounting at San Jose State University, a MAcc
degree in tax at Brigham Young University, and a PhD in accounting from the University of Georgia (so he is now teaching at a second alma mater).
Professor Christensen has authored and coauthored articles published in many journals including The Accounting Review, Journal of Accounting Research,
Journal of Accounting and Economics, Review of Accounting Studies, Contemporary Accounting Research, Accounting Organizations and Society, Journal
of Business Finance & Accounting, Accounting Horizons, and Issues in Accounting Education. Professor Christensen has taught financial accounting at all
levels, financial statement analysis, both introductory and intermediate managerial accounting, and corporate taxation. He is the recipient of numerous awards
for both teaching and research. He has been active in serving on various committees of the American Accounting Association and is a CPA.
Courtesy Brigham Young University/Photo by Kristen Gudmund
David M. Cottrell
Professor Cottrell joined the faculty at Brigham Young University in 1991. Prior to coming to BYU, he spent five years at The Ohio State University where he
earned his PhD. Before pursuing a career in academics, he worked as an auditor and consultant for the firm of Ernst & Young in its San Francisco office. At
BYU, Professor Cottrell has developed and taught courses in the School of Accountancy, the MBA program, and the Finance program. He has won
numerous awards from the alumni and faculty for his teaching and curriculum development. He received the Outstanding Professor Award in the college of
business as selected by the students in the Finance Society; he received the Outstanding Teaching Award as selected by the Marriott School of Management;
and he is a four-time winner of the collegewide Teaching Excellence Award for Management Skills, which is selected by the Alumni Board of the Marriott
School of Management at BYU. Professor Cottrell also has authored many articles about accounting and auditing issues. His articles have been published in
Issues in Accounting Education, Journal of Accounting Case Research, Quarterly Review of Distance Education, Journal of Accountancy, The CPA Journal,
Internal Auditor, The Tax Executive, and Journal of International Taxation, among others.
Courtesy Brigham Young University/Photo by Tabitha Sumsion
Cassy JH Budd
Professor Budd has been a faculty member at Brigham Young University since 2005. Prior to coming to BYU, she was on the faculty at Utah State University
for three years. She received a BS degree in accounting at Brigham Young University and a MAcc degree in tax at Utah State University. Before pursuing a
career in academics, she worked as an auditor for the firm of PricewaterhouseCoopers LLP in its Salt Lake, San Jose, and Phoenix offices and continues to
maintain her CPA license. Professor Budd has taught financial accounting at all levels, as well as introductory managerial accounting, undergraduate and
graduate auditing, and partnership taxation. She is the recipient of numerous awards for teaching and student advisement, including the Dean Fairbanks
Teaching and Learning Faculty Fellowship, Brigham Young University; School of Accountancy Advisor of the Year, Utah State University; State of Utah
Campus Compact Service-Learning Engaged Scholar Award, and the Joe Whitesides Scholar–Athlete Recognition Award from Utah State page vi
University. She has been active in serving on various committees of the American Accounting Association, including chairing the annual
Conference on Teaching and Learning in Accounting. Professor Budd is currently serving as the President of the Teaching, Learning and Curriculum Section
of the American Accounting Association.
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Preface
The Twelfth Edition of Advanced Financial Accounting is an up-to-date, comprehensive, and highly illustrated presentation of the accounting and reporting
principles and procedures used in a variety of business entities. Every day, the business press carries stories about merger and acquisition mania, the
complexities of modern business entities, new organizational structures for conducting business, accounting scandals related to complex business
transactions, the foreign activities of multinational firms, the operations of governmental and not-for-profit entities, and bankruptcies of major firms.
Accountants must understand and know how to deal with the accounting and reporting ramifications of these issues.
OVERVIEW
As in prior editions, this edition provides detailed coverage of advanced accounting topics with clarity and integrated coverage based on continuous case
examples. The text is complete with illustrations of worksheets, schedules, and financial statements allowing students to see the development of each topic.
Inclusion of recent FASB and GASB pronouncements and the continuing deliberations of the authoritative bodies provide a current and contemporary text for
students preparing for the CPA examination and current practice. This emphasis has become especially important given the recent rapid pace of the
authoritative bodies in dealing with major issues having far-reaching implications. The Twelfth Edition covers the following topics:
Multicorporate Entities
Business Combinations
1. Intercorporate Acquisitions and Investments in Other Entities
Consolidation Concepts and Procedures
2. Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with
No Differential
3. The Reporting Entity and the Consolidation of Less-than-Wholly-Owned Subsidiaries with No
Differential
4. Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
5. Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
Intercompany Transfers
6. Intercompany Inventory Transactions
7. Intercompany Transfers of Services and Noncurrent Assets
8. Intercompany Indebtedness
Additional Consolidation Issues
9. Consolidation Ownership Issues
10. Additional Consolidation Reporting Issues
Multinational Entities
Foreign Currency Transactions
11. Multinational Accounting: Foreign Currency Transactions and Financial Instruments
Translation of Foreign Statements
12. Multinational Accounting: Issues in Financial Reporting and Translation of Foreign Entity
Statements
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Reporting Requirements
Segment and Interim Reporting
13. Segment and Interim Reporting
SEC Reporting
14. SEC Reporting
Partnerships
Formation, Operation, Changes
15. Partnerships: Formation, Operation, and Changes in Membership
Liquidation
16. Partnerships: Liquidation
Governmental and Not-for-Profit Entities
Governmental Entities
17. Governmental Entities: Introduction and General Fund Accounting
Special Funds
18. Governmental Entities: Special Funds and Governmentwide Financial Statements
Not-for-Profit
19. Not-for-Profit Entities
Corporations in Financial Difficulty
20. Corporations in Financial Difficulty
NEW FEATURES ADDED IN THE TWELFTH EDITION
New shading of consolidation worksheet entries. In the Twelfth Edition we have added full-color coordination of all consolidation items including (1)
calculations, (2) consolidation journal entries, (3) T-accounts, and (4) worksheets. The full-color coordination allows teachers and students to see the
development of each item and trace these items visually through the consolidation process. For example, each number in the Book Value Calculations can be
traced to the Basic Consolidation Entry.
Likewise, the calculations in the Excess Value (Differential) Calculations can be traced to either the Amortized Excess Value Reclassification Entry or the
Excess Value (Differential) Reclassification Entry. In the Computation table, color application helps text users to quickly and clearly distinguish
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between Amortization amounts related to the current year and the current year Ending Balance for each item. The same colors help users to
quickly connect these calculations to the consolidation entries.
Users can continue using colors to quickly connect the impact of the consolidation entries as they visualize how each of these entries impact the equity
accounts. With these connections, users can follow items through calculations, consolidation entries, and T-accounts. This approach helps users to see the
interaction of the equity entries and the consolidation entries in fully eliminating the “Investment in Sub” and the “Income from Sub Accounts.” These color
connections are illustrated in the calculations, consolidation entries, and T-accounts that follow.
Users can continue the visual connections from the entries and the T-accounts all the way through the consolidation worksheet as shown in the following
example. We have extended this shading not only to the worksheets but also to supporting schedules and calculation boxes so that numbers appearing in
consolidation worksheet entries are uniformly shaded in all locations.
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F I G U R E 5 –4
December 31, 20X1, Equity-Method Worksheet for Consolidated Financial Statements, Initial Year of Ownership; 80 Percent Acquisition
at More than Book Value
KEY FEATURES MAINTAINED IN THE TWELFTH EDITION
The key strengths of this text are the clear and readable discussions of concepts and their detailed demonstrations through illustrations and explanations. The
many favorable responses to prior editions from both students and instructors confirm our belief that clear presentation and comprehensive illustrations are
essential to learning the sophisticated topics in an advanced accounting course. Key features maintained in the Twelfth Edition include:
Callout boxes. We have updated the “callout boxes” that appear in the margins to draw attention to important
points throughout the chapters. The most common callout boxes are the “FYI” boxes, which often illustrate how
real-world companies or entities apply the principles discussed in the various chapters. The “Caution” boxes
draw students’ attention to common mistakes and explain how to avoid them. The “Stop & Think” boxes help
students take a step back and think through the logic of difficult concepts.
FASB codification. Authoritative citations to U.S. GAAP are cited based on the FASB codification.
Introductory vignettes. Each chapter begins with a brief story of a well-known company to illustrate page xi
why topics covered in that chapter are relevant in current practice. Short descriptions of the vignettes
and the featured companies are included in the Chapter-by-Chapter Changes section at the end of the Preface.
A building-block approach to consolidation. Virtually all advanced financial accounting classes cover
consolidation topics. Although this topic is perhaps the most important to instructors, students frequently
struggle to gain a firm grasp of consolidation principles. The Twelfth Edition provides students a learningfriendly framework to consolidations by introducing consolidation concepts and procedures more gradually.
This is accomplished by a building-block approach that introduces consolidations in Chapters 2 and 3 and
continues through Chapter 5.
IFRS comparisons. While the FASB and IASB had worked toward convergence to a single set of global
accounting standards in the past, differences between the two framework persist. The Twelfth Edition
summarizes existing key differences between current U.S. GAAP and IFRS where applicable.
AdvancedStudyGuide.com. See the section High Tech: The Twelfth Edition Adds Key Technology Resources
to Benefit Both Students and Instructors for details.
The use of a continuous case for each major subject-matter area. This textbook presents the complete story
of a company, Peerless Products Corporation, from its beginning through its growth to a multinational
consolidated entity and finally to its end. At each stage of the entity’s development, including the acquisition of
a subsidiary, Special Foods Inc., the text presents comprehensive examples and discussions of the accounting
and financial reporting issues that accountants face. The discussions tied to the Peerless Products continuous
case are easily identified by the company logos in the margin:
We use the comprehensive case of Peerless Products Corporation and its subsidiary, Special Foods Inc.,
throughout the for-profit chapters. For the governmental chapters, the Sol City case facilitates the development
of governmental accounting and reporting concepts and procedures. Using a continuous case provides several
benefits. First, students need to become familiar with only one set of data and can then move more quickly
through the subsequent discussion and illustrations without having to absorb a new set of data. Second, the case
adds realism to the study of advanced accounting and permits students to see the effects of each successive step
on an entity’s financial reports. Finally, comparing and contrasting alternative methods using a continuous case
allows students to evaluate different methods and outcomes more readily.
Extensive illustrations of key concepts. The book is heavily illustrated with complete, not partial,
workpapers, financial statements, and other computations and comparisons useful for demonstrating each topic.
The illustrations are cross-referenced to the relevant text discussion. In the consolidations portion of the text,
the focus is on the fully adjusted equity method of accounting for an investment in a subsidiary, but two other
methods—the cost method and the modified equity method—are also discussed and illustrated in chapter
appendixes.
Comprehensive coverage with significant flexibility. The subject matter of advanced accounting is expanding
at an unprecedented rate. New topics are being added, and traditional topics require more extensive coverage.
Flexibility is therefore essential in an advanced accounting text. Most one-term courses are unable to cover all
topics included in this text. In recognition of time constraints, this text is structured to provide the most efficient
use of the time available. The self-contained units of subject matter allow for substantial flexibility in
sequencing the course materials. In addition, individual chapters are organized to allow for more depth in some
topics through the use of the “Additional Considerations” sections. Several chapters include appendixes
containing discussions of alternative accounting procedures or illustrations of procedures or concepts that are
of a supplemental nature.
Extensive end-of-chapter materials. A large number of questions, cases, exercises, and problems at page xii
the end of each chapter provide the opportunity to solidify understanding of the chapter material and
assess mastery of the subject matter. The end-of-chapter materials progress from simple focused exercises to
more complex integrated problems. Cases provide opportunities for extending thought, gaining exposure to
different sources of accounting-related information, and applying the course material to real-world situations.
These cases include research cases that refer students to authoritative pronouncements and Roger CPA Review
simulations. The American Institute of CPAs has identified five skills to be examined as part of the CPA exam:
(a) analysis, (b) judgment, (c) communication, (d) research, and (e) understanding. The end-of-chapter
materials provide abundant opportunities for students to enhance those skills with realistic and real-world
applications of advanced financial accounting topics. Cases and exercises identified with a world globe icon
provide special opportunities for students to access real-world data by using electronic databases, the Internet,
or other inquiry processes to answer the questions presented on the topics in the chapters.
TEGRITY: LECTURES 24/7
Tegrity® is a service that makes class time available 24/7 by automatically capturing every lecture. With a simple one-click start-and-stop process, you
capture all computer screens and corresponding audio in a format that is easily searchable, frame by frame. Students can replay any part of any class with
easy-to-use browser-based viewing on a PC, Mac, or mobile device.
Help turn your students’ study time into learning moments immediately supported by your lecture. With Tegrity, you also increase intent listening and
class participation by easing students’ concerns about note taking. Lecture Capture will make it more likely you will see students’ faces, not the tops of their
heads.
To learn more about Tegrity, watch a two-minute Flash demo at http://tegritycampus.mhhe.com.
CUSTOM PUBLISHING THROUGH CREATE
McGraw-Hill Create™ is a new, self-service website that allows instructors to create custom course materials by drawing upon McGraw-Hill’s
comprehensive, cross-disciplinary content. Instructors can add their own content quickly and easily and tap into other rights-secured third-party sources as
well, then arrange the content in a way that makes the most sense for their course. Instructors can even personalize their book with the course name and
information and choose the best format for their students—color print, black-and-white print, or an eBook.
Through Create, instructors can
Select and arrange the content in a way that makes the most sense for their course.
Combine material from different sources and even upload their own content.
Choose the best format for their students—print or eBook.
Edit and update their course materials as often as they’d like.
Begin creating now at www.mcgrawhillcreate.com.
ASSURANCE OF LEARNING READY
Many educational institutions today focus on the notion of assurance of learning, an important element of some accreditation standards. Advanced Financial
Accounting is designed specifically to support your assurance of learning initiatives with a simple yet powerful solution.
Each test bank question for Advanced Financial Accounting maps to a specific chapter learning outcome/objective listed in the text. You can use our test
bank software, TestGen, or McGraw-Hill’s Connect Accounting to easily query for learning outcomes/objectives that directly relate to the
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learning objectives for your course. You can then use the reporting features of TestGen to aggregate student results in a similar fashion,
making the collection and presentation of assurance of learning data simple and easy.
MCGRAW-HILL CUSTOMER CARE CONTACT INFORMATION
At McGraw-Hill, we understand that getting the most from new technology can be challenging. That’s why our services don’t stop after you purchase our
products. You can contact our Technical Support Analysts 24 hours a day to get product training online, or you can search our knowledge bank of
Frequently Asked Questions on our support website. For Customer Support, call 800-331-5094 or visit www.mhhe.com/support. One of our Technical
Support Analysts will be able to assist you in a timely fashion.
AACSB STATEMENT
The McGraw-Hill Companies is a proud corporate member of AACSB International. Understanding the importance and value of AACSB accreditation,
Advanced Financial Accounting Twelfth Edition recognizes the curricula guidelines detailed in the AACSB standards for business accreditation by connecting
selected questions in the text and the test bank to the six general knowledge and skill guidelines in the AACSB standards.
The statements contained in Advanced Financial Accounting Twelfth Edition are provided only as a guide for the users of this textbook. The AACSB
leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. Although Advanced Financial
Accounting Twelfth Edition and the teaching package make no claim of any specific AACSB qualification or evaluation, we have within Advanced Financial
Accounting Twelfth Edition labeled selected questions according to the six general knowledge and skills areas.
ROGER CPA
McGraw-Hill Education has partnered with Roger CPA Review, a global leader in CPA Exam preparation, to provide students a smooth transition from the
accounting classroom to successful completion of the CPA Exam. While many aspiring accountants wait until they have completed their academic studies to
begin preparing for the CPA Exam, research shows that those who become familiar with exam content earlier in the process have a stronger chance of
successfully passing the CPA Exam. Accordingly, students using these McGraw-Hill materials will have access to sample CPA Exam Task-based Simulations
from Roger CPA Review, with expert-written explanations and solutions. All questions are either directly from the AICPA or are modeled on AICPA questions
that appear in the exam. Task-based Simulations are delivered via the Roger CPA Review platform, which mirrors the look, feel, and functionality of the
actual exam. McGraw-Hill Education and Roger CPA Review are dedicated to supporting every accounting student along their journey, ultimately helping
them achieve career success in the accounting profession. For more information about the full Roger CPA Review program, exam requirements and exam
content, visit www.rogercpareview.com.
HIGH TECH: THE TWELFTH EDITION ADDS KEY TECHNOLOGY
RESOURCES TO BENEFIT BOTH STUDENTS AND INSTRUCTORS
Connect is a teaching and learning platform that is proven to deliver better results for students and instructors. Connect is available with the
twelfth edition, offering assignable end-of-chapter materials, test bank assessment material, and SmartBook. By using Connect, instructors can ensure that
students are prepared ahead of class, thus freeing up instructors to discuss a broader range of topics in their lectures and in the give-and-take between
teacher and student. Connect Insight Reports will also give the instructor a better view into the overall class’s understanding of core topics prior to class to
appropriately focus lectures and discussion. The Connect Library also offers materials to support the efforts of first-time and seasoned instructors of
accounting ethics, including a comprehensive Instructor’s Manual, Test Bank, and PowerPoint presentations.
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McGraw-Hill Connect ® is a highly reliable, easy-to-use homework
and learning management solution that utilizes learning science
and award-winning adaptive tools to improve student results.
Homework and Adaptive Learning
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Connect’s assignments help students contextualize what they’ve learned through application,
so they can better understand the material and think critically.
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Connect will create a personalized study path customized to individual student needs through
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Over 7 billion questions have been answered, making
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Connect content is authored by the world’s best subject matter experts, and is available to
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The Connect eBook makes it easy for students to access their reading material on smartphones
and tablets. They can study on the go and don’t need internet access to use the eBook as a
reference, with full functionality.
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Multimedia content such as videos, simulations, and games drive student engagement and critical
thinking skills.
73% of instructors who use Connect require it; instructor
satisfaction increases by 28% when Connect is required.
©McGraw-Hill Education
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Robust Analytics and Reporting
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Connect Insight® generates easy-to-read reports on individual students, the class as a whole,
and on specific assignments.
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The Connect Insight dashboard delivers data on performance, study behavior, and effort.
Instructors can quickly identify students who struggle and focus on material that the class has
yet to master.
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Connect automatically grades assignments and quizzes, providing easy-to-read reports on
individual and class performance.
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More students earn As and Bs when they use Connect.
Trusted Service and Support
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Connect integrates with your LMS to provide single sign-on and automatic syncing of grades.
Integration with Blackboard®, D2L®, and Canvas also provides automatic syncing of the course
calendar and assignment-level linking.
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Connect offers comprehensive service, support, and training throughout every phase of your
implementation.
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If you’re looking for some guidance on how to use Connect, or want to learn tips and tricks
from super users, you can find tutorials as you work. Our Digital Faculty Consultants and
Student Ambassadors offer insight into how to achieve the results you want with Connect.
www.mheducation.com/connect
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Available within Connect, SmartBook makes study time as productive and efficient as possible. It identifies and closes knowledge gaps through a
continually adapting reading experience that provides personalized learning resources at the precise moment of need. This ensures that every minute spent
with SmartBook is returned to the student as the most value-added minute possible. The result? More confidence, better grades, and greater success.
Available on smartphones and tablets, SmartBook puts learning at the student’s fingertips—anywhere, anytime.
The Twelfth Edition of Advanced Financial Accounting continues and expands one of the most student-centered technology supplements ever delivered
in the advanced accounting market. AdvancedStudyGuide.com is a product created exclusively by the text authors that represents a new generation in study
resources available to students as well as a new direction and options in the resources instructors can use to help their students and elevate their classroom
experiences.
Traditional study guides offer students a resource similar to the text itself—that is, more discussion like the text accompanied by more problems and
exercises like the ones in the text at a fairly high price to give students the same type of materials that have they already received with the text.
At its core, AdvancedStudyGuide.com (ASG) offers materials that go beyond what a printed text can possibly deliver. The ASG contains dozens of
narrated, animated discussions and explanations of materials aligned to key points in the chapter. Not only that, the ASG also contains animated problems just
like key problems in the exercises and problems at the end of each chapter. For the student who would like a little help with Advanced Financial Accounting,
the ASG is like having private tutoring sessions from the authors who wrote the book (not a class TA) any time, day or night. This also can provide
tremendous benefits for instructors, as outlined below.
For Students
The Questions
Have you ever had to miss a class and were then confused about what the book was trying to say about a topic?
Even when you were in class, do things sometimes not make as much sense when you are reviewing on your
own?
Do you ever feel stuck when it comes to doing homework problems even though you read the chapter?
When the exam is a few weeks after you covered the material in class, do you ever wish someone could walk
you through a few examples as you review for the exam?
Have you ever purchased a study guide for a text and found it was very expensive and did not give the
additional study help you needed?
The ASG Answer
The answer, at least in part, is the ASG: a new type of study guide designed for the way you like to study and
the way that you learn best.
It is our attempt as authors to really discuss the material in a way that a text-only approach cannot do.
AND we can discuss your questions with you 24/7, anytime, day or night, at times when your regular instructor
is not around.
Through the ASG, we will bring you streaming media discussions by the authors of the book (not a class TA) to
explain key points of each chapter.
The ASG will also show, explain, and illustrate for you the approach to solving key homework problems in the
text. These explanations are Like Problems; that is, they are problems “just like” some in the text that you were
assigned for homework.
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The ASG Benefit
AdvancedStudyGuide.com brings you discussion and examples worked out in streaming video. Although traditional study guides can Tell you what to do, the
ASG will Show You What to Do, How to Do it, and WHY We Do It.
See the student page at AdvancedStudyGuide.com.
For Instructors
The Questions
Have you ever had a student miss class and then come to your office and ask you to go over the topics that were
discussed in class the day the student was absent?
Even when a student is in class, does he or she sometimes come to your office and ask you to repeat the
discussion?
Even when you have discussed the chapter concepts, do you have students who still get stuck when it comes to
doing homework problems?
When exams are approaching, do students sometimes ask you to go back over material you taught days or weeks
before?
Would it be helpful to you if, on occasion, the authors of the text offered to hold “office hours” with your
students for you?
The ASG Answer
The answer, at least in part, is the ASG: the authors’ attempt to partner with you in helping to better serve
students’ needs in some of the common situations where questions arise, without using more of your scarce time.
The ASG will allow you to refer to streaming media discussions where the authors explain key points of each
chapter.
The ASG will show, explain, and illustrate for students the approach to solving key homework problems in the
text. These explanations are Like Problems; that is, they are problems “just like” some in the text that you can
assign for homework.
The ASG Benefit
AdvancedStudyGuide.com is a great tool to let the authors of the text partner with you, the instructor, in helping students learn Advanced Financial
Accounting. The ASG will (1) help your students learn more effectively, (2) improve your class discussions, and (3) make your student contact hours more
efficient.
See the instructor page at AdvancedStudyGuide.com.
CHAPTER-BY-CHAPTER CHANGES
Chapter 1 emphasizes the importance of business acquisitions and combinations. The chapter has been
significantly reorganized and updated based on feedback from textbook adopters to provide a clearer and more
concise discussion of the accounting treatment of mergers, acquisitions, and other intercorporate investments.
We have added new illustrations and updated the beginning-of-chapter vignette and callout boxes to provide
real-world examples of the topics discussed in the chapter, most of which provide additional information about
the Microsoft example in the introductory vignette.
Chapter 2 summarizes the different types of intercorporate investments. The coverage in this chapter, which is
specific to accounting for equity securities, has been updated with guidance from ASU 2016-01, which is
codified into ASC 321. This chapter also introduces consolidation in the most straightforward scenario—where
the parent company acquires full ownership of the subsidiary for an amount equal to the subsidiary’s book value
(i.e., no differential). Based on the new full-color shading introduced in the Twelfth Edition, this page xviii
chapter introduces a new method of shading our consolidation worksheet entries to make them
easily distinguishable by the reader. We have updated this chapter to provide a more streamlined and
understandable coverage of topics traditionally included in this chapter. Finally, we have updated the “callout
boxes” that provide real-world examples of the topics discussed in the chapter, some of which provide
additional information about Berkshire Hathaway’s investments discussed in the introductory vignette.
Chapter 3 explores how the basic consolidation process differs when a subsidiary is only partially owned.
Moreover, it introduces the notion of special-purpose entities and accounting standards related to variable
interest entities (VIE) by discussing the Coca-Cola Company. This chapter includes updated FASB guidance in
ASC 810 related to the characteristics of a VIE and the primary beneficiary or reporting entity. We have
streamlined and shortened this chapter based on feedback from adopters to provide a better flow for the
material. In addition, we have updated the callout boxes to help students understand the intricacies associated
with the consolidation of a partially owned subsidiary and dealing with variable interest entities.
Chapter 4 gives a behind-the-scenes look at the work that goes into the consolidation process based on Disney
Corporation including its new investment in BAMTech, which holds Major League Baseball’s streaming
technology and content delivery business. This chapter introduces consolidation of wholly owned subsidiaries
with a differential, which results in situations in which the acquiring company pays more than the book value of
the acquired company’s net assets. This chapter adds a detailed explanation of the new shading of the
consolidation worksheet entries introduced in Chapter 2.
Chapter 5 introduces majority ownership of subsidiaries based on the 51 percent acquisition of Massmart by
Walmart. We further the discussion of acquisitions with a differential that has the added complexity of
noncontrolling interest shareholders when they purchase less than 100 percent of the outstanding common stock.
We have simplified the coverage of some of the topics in this chapter and removed tangential topics to provide
more concise coverage of the important material.
Chapter 6 introduces intercompany inventory transfers based on Samsung Electronics and its subsidiaries,
which accounted for 58 percent of Samsung’s total revenues in 2016. The elimination of intercompany profits
can become complicated. In fact, intercompany inventory transactions and the consolidated procedures
associated with them represent one of the topics textbook adopters have found most difficult to teach to
students. As a result, we have rewritten this with added illustrations to better simplify adjustments to the basic
consolidation entry in both the year when an intercompany sale of inventory leads to a deferral of gross profit
(Year 1), and the next year when this deferral is reversed (Year 2). In addition, we have added a series of new
callout boxes to draw students’ attention to the subtle complexities that our students have frequently struggled to
understand.
Chapter 7 presents a real fixed asset transfer between two of Micron’s subsidiaries. This chapter explores the
accounting for both depreciable and nondepreciable asset transfers among affiliated companies. Continuing the
coverage of intercompany transfers from Chapter 6, Chapter 7 is one of the most difficult to teach for many
adopters. Therefore, we have spent considerable time revising this chapter including a new three-year
comprehensive example of an intercompany sale of land. We have also reorganized some of the material and
have added illustrations to better simplify adjustments to the basic consolidation entry and new graphics to
simplify difficult topics.
Chapter 8 begins with a new example of how intercompany indebtedness played a significant role in the
resolution of the bankruptcy of Caesars Entertainment Corporation’s (CEC) largest casino operating
subsidiary, Caesars Entertainment Operating Company, Inc. (CEOC). This edition continues the page xix
the use of the effective interest method in the body of the chapter with coverage of the straight-line
method illustrated in the appendix to the chapter.
Chapter 9 returns to the discussion of Berkshire Hathaway to demonstrate that, in practice, ownership
situations can be complex. The discussion here provides a basic understanding of some of the consolidation
problems arising from complex situations commonly encountered in practice, including but not limited to
changes in the parent’s ownership interest and multiple ownership levels. We have revised the chapter to clarify
some of these complex transactions.
Chapter 10 uses the example of the rapid growth of Alphabet (formerly Google Inc.) to explore four
additional issues related to consolidated financial statements: the consolidated statement of cash flows,
consolidation following an interim acquisition, consolidated tax considerations, and consolidated earnings per
share. We have revised the chapter to clarify and expand some of the illustrative examples.
Chapter 11 focuses on foreign currency transactions, financial instruments, and the effects that changes in
exchange rates can have on reported results. We provide real-world examples of the topics discussed in the
chapter, including the introductory vignette about Microsoft. We have revised this chapter to clarify the
illustrations related to the use of forward contracts as hedging instruments and to update examples for recent
changes in accounting standards.
Chapter 12 resumes the discussion of international accounting by exploring McDonald’s global empire and
how differences in accounting standards across countries and jurisdictions can cause significant difficulties for
multinational firms. We have revised the chapter to clarify the narrative based on feedback from adopters and
students and to update some of the discussion for recent changes in accounting standards.
Chapter 13 examines segment reporting. We have made minor revisions to more clearly discuss the accounting
standards for reporting an entity’s operating components, foreign operations, and major customers and have
updated the callout boxes illustrating how real companies, including Walmart from the introductory vignette,
deal with segment reporting issues.
Chapter 14 reviews the complex role of the Securities and Exchange Commission to regulate trades of
securities and to determine the type of financial disclosures that a publicly held company must make. We have
made light revisions to update the coverage for recent laws and regulations.
Chapter 15 uses the example of PricewaterhouseCoopers to summarize the evolution of the original Big 8
accounting firms to today’s Big 4 with an emphasis on partnerships. This chapter focuses on the formation and
operation of partnerships, including accounting for the addition of new partners and the retirement of a present
partner. We have made light revisions to the chapter to better explain partnership accounting.
Chapter 16 illustrates the dissolution of partnerships with the example of Laventhol & Horwath, the seventhlargest accounting firm in 1990. We have made light revisions to clarify some of the more difficult concepts
related to partnership liquidation.
Chapter 17 introduces the topic of accounting for governmental entities. The chapter has two parts: the
accounting and reporting requirements for state and local governmental units and a comprehensive illustration
of accounting for a city’s general fund. We have made light revisions to better explain some topics that students
have found to be most difficult. Moreover, we have updated the callout boxes (most of which highlight specific
examples related to the introductory vignette about San Diego, California) to clarify various topics.
Chapter 18 resumes the discussion of accounting for governmental entities by specifically examining special
funds and governmentwide financial statements. We have lightly revised the chapter topics that are page xx
often misunderstood by students and have updated the callout boxes (which highlight specific
examples related to the introductory vignette about the state of Maryland). Moreover, we have added some
additional details related to more recent GASB pronouncements that were not included in the last edition.
Chapter 19 introduces accounting for not-for-profit entities using the example of United Way Worldwide, the
largest charitable organization in the United States. We present the accounting and financial reporting principles
used by both governmental and nongovernmental colleges and universities, health care providers, voluntary
health and welfare organizations, and other not-for-profit organizations such as professional and fraternal
associations. We have updated the chapter extensively based on new standards related to the presentation of net
assets for not-for-profit entities (ASU 2016-14, ASC 958-210).
Chapter 20 introduces our final topic of corporations in financial difficulty by illustrating General Motors
Company (GM) and its Chapter 11 bankruptcy protection granted in 2009. GM’s experience illustrates that
dealing with financial difficulty can be a long and complicated process, especially for large corporations. We
present the range of major actions typically used by such a company. We have made minor revisions to the
chapter content and have updated the callout boxes to highlight recent well-publicized bankruptcies.
page xxi
Acknowledgments
This text includes the thoughts and contributions of many individuals, and we wish to express our sincere appreciation to them. First and foremost, we thank
all the students in our advanced accounting classes from whom we have learned so much. In many respects, this text is an outcome of the learning
experiences we have shared with our students. Second, we wish to thank the many outstanding teachers we have had in our own educational programs from
whom we learned the joy of learning. We are indebted to our colleagues in advanced accounting for helping us reach our goal of writing the best possible
advanced financial accounting text. We appreciate the many valuable comments and suggestions from the faculty who used recent editions of the text. Their
comments and suggestions have contributed to making this text a more effective learning tool. We especially wish to thank Stacie Hughes of Athens State
University, Lauren Materne and James Shinners from the University of Michigan, Melissa Larson from Brigham Young University, and Sheldon Smith from
Utah Valley University.
We express our sincere thanks to the following individuals who provided reviews on the previous editions:
Andrea Astill
Indiana University–Bloomington
Jason Bergner
University of Central Missouri
Fatma Cebenoyan
Hunter College
Bobbie Daniels
Jackson State University
Carlos Diaz
Johnson & Wales University
David Doyon
Southern New Hampshire University
Cobby Harmon
University of California–Santa Barbara
Mark Holtzman
Seton Hall University
Charles Lewis
University of Houston–Downtown
Stephani Mason
Hunter College
Mallory McWilliams
University of California–Santa Cruz
Barbara Reeves
Cleary University
Sara Reiter
Binghamton University
Tom Rosengarth
Bridgewater College
Chantal Rowat
Bentley University
Mike Slaubaugh
Indiana University-Purdue University–Fort Wayne
Hannah Wong
William Paterson University
We are grateful for the assistance and direction of the McGraw-Hill team: Tim Vertovec, Rebecca Olson, Zachary Rudin, Kevin Moran, Janine Loechel,
Danielle McLimore, Pat Frederickson, Jessica Cuevas, and Brian Nacik, who all worked hard to champion our book through the production process.
We thank Roger CPA Review for providing its online framework for Advanced Financial Accounting students to gain important experience with the types
of simulations that are included on the Uniform CPA Examination.
Above all, we extend our deepest appreciation to our families who continue to provide the encouragement and support necessary for this project.
Theodore E. Christensen
David M. Cottrell
Cassy JH Budd
page xxii
Brief Table of Contents
PREFACE
vii
1. Intercorporate Acquisitions and Investments in Other Entities
1
2. Reporting Intercorporate Investments and Consolidation of Wholly Owned
Subsidiaries with No Differential 46
3. The Reporting Entity and the Consolidation of Less-than-Wholly-Owned
Subsidiaries with No Differential 95
4. Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
136
5. Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book
Value 189
6. Intercompany Inventory Transactions
236
7. Intercompany Transfers of Services and Noncurrent Assets
8. Intercompany Indebtedness
298
374
9. Consolidation Ownership Issues
452
10.
Additional Consolidation Reporting Issues
11.
Multinational Accounting: Foreign Currency Transactions and Financial Instruments
548
12.
Multinational Accounting: Issues in Financial Reporting and Translation of Foreign
Entity Statements 621
13.
Segment and Interim Reporting
14.
SEC Reporting
15.
Partnerships: Formation, Operation, and Changes in Membership
16.
Partnerships: Liquidation
17.
Governmental Entities: Introduction and General Fund Accounting
18.
Governmental Entities: Special Funds and Governmentwide Financial Statements
907
19.
Not-for-Profit Entities
503
683
730
758
811
973
849
20.
INDEX
Corporations in Financial Difficulty
1077
1043
page xxiii
Table of Contents
ABOUT THE AUTHORS
PREFACE
v
vii
Chapter 1
Intercorporate Acquisitions and Investments in other Entities
Microsoft’s Acquisition of Linkedin 1
An Introduction to Complex Business Structures
Enterprise Expansion 2
Business Objectives 2
Frequency of Business Combinations
Ethical Considerations 4
2
3
Business Expansion and Forms of Organizational Structure
5
Internal Expansion: Creating a Business Entity 5
External Expansion: Business Combinations 6
Organizational Structure and Financial Reporting 7
The Development of Accounting for Business Combinations 8
Accounting for Internal Expansion: Creating Business Entities 8
Accounting for External Expansion: Business Combinations 10
Legal Forms of Business Combinations 10
Methods of Effecting Business Combinations
Valuation of Business Entities 12
Acquisition Accounting
11
14
Fair Value Measurements 14
Applying the Acquisition Method 14
Goodwill 14
Combination Effected through the Acquisition of Net Assets
Combination Effected through Acquisition of Stock 20
Financial Reporting Subsequent to a Business Combination
15
20
Additional Considerations in Accounting for Business Combinations
Uncertainty in Business Combinations 21
In-Process Research and Development 22
Noncontrolling Equity Held Prior to Combination
Summary of Key Concepts
Key Terms 24
23
23
21
1
Questions 24
Cases 25
Exercises 26
Problems 37
Chapter 2
Reporting Intercorporate Investments and Consolidation of Wholly Owned
Subsidiaries with No Differential 46
Berkshire Hathaway’s Many Investments 46
Accounting for Investments in Common Stock 47
Securities Carried at Fair Value 50
Accounting Procedures for Securities Carried at Fair Value
Changes in the Number of Shares Held 50
The Equity Method
50
51
Use of the Equity Method 51
Investor’s Equity in the Investee 52
Recognition of Income 52
Recognition of Dividends 52
Carrying Amount of the Investment and Investment Income under the Equity Method
Changing to the Equity Method at an Interim Date 53
Acquisition at Interim Date 53
Changes in the Number of Shares Held 54
53
Investments Carried at Fair Value and Investments Accounted for Using the Equity Method 55
Overview of the Consolidation Process 56
Consolidation Procedures for Wholly Owned Subsidiaries that are Created or Purchased at Book Value
Consolidation Worksheets 57
Worksheet Format 57
Nature of Consolidation Entries
59
Consolidated Balance Sheet with Wholly Owned Subsidiary
100 Percent Ownership Acquired at Book Value
Consolidation Subsequent to Acquisition
Consolidated Net Income 65
Consolidated Retained Earnings
59
60
64
65
Consolidated Financial Statements—100 Percent Ownership, Created or Acquired at Book Value
Initial Year of Ownership 67
Second and Subsequent Years of Ownership 70
Consolidated Net Income and Retained Earnings
Summary of Key Concepts
57
66
73
73
APPENDIX 2A
Additional Considerations Relating to the Equity Method
Key Terms 74
74
APPENDIX 2B
Consolidation when Parent Companies Choose to Carry at Cost Investments that are to be Consolidated
77
page xxiv
Questions 80
Cases 81
Exercises 83
Problems 89
Roger CPA Review
94
Chapter 3
The Reporting Entity and the Consolidation of Less-than-Wholly-Owned Subsidiaries
with No Differential 95
The Coca-Cola Company 95
The Usefulness of Consolidated Financial Statements 96
Limitations of Consolidated Financial Statements 97
Subsidiary Financial Statements 97
Consolidated Financial Statements: Concepts and Standards
Traditional View of Control 98
Indirect Control 98
Ability to Exercise Control 99
Differences in Fiscal Periods 99
Changing Concept of the Reporting Entity
Noncontrolling Interest
98
99
100
Computation and Presentation of Noncontrolling Interest
The Effect of a Noncontrolling Interest
Consolidated Net Income 102
Consolidated Retained Earnings
Worksheet Format 104
100
101
103
Consolidated Balance Sheet with a Less-than-Wholly-Owned Subsidiary
80 Percent Ownership Acquired at Book Value
105
105
Consolidation Subsequent to Acquisition—80 Percent Ownership Acquired at Book Value
Initial Year of Ownership 108
Second and Subsequent Years of Ownership
Combined Financial Statements 114
Special-Purpose and Variable Interest Entities
112
115
Variable Interest Entities 115
IFRS Differences in Determining Control of VIEs and SPEs
Summary of Key Concepts
118
APPENDIX 3A
Consolidation of Variable Interest Entities
Key Terms 119
Questions 120
Cases 121
Exercises 122
Problems 129
119
117
108
Chapter 4
Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
How Much Work Does it Really Take to Consolidate? Ask the People Who Do it at Disney
Dealing with the Differential 137
The Difference between Acquisition Price and Underlying Book Value
Additional Considerations
136
136
138
141
Disney’s 2006 Pixar Acquisition 141
Disney’s 2012 Lucasfilm Acquisition 142
Consolidation Procedures for Wholly Owned Subsidiaries Acquired at More than Book Value
Treatment of a Positive Differential 146
Illustration of Treatment of a Complex Differential 147
100 Percent Ownership Acquired at Less than Fair Value of Net Assets
Illustration of Treatment of Bargain-Purchase 151
143
151
Consolidated Financial Statements—100 Percent Ownership Acquired at More than Book Value
153
Initial Year of Ownership 153
Second Year of Ownership 158
Intercompany Receivables and Payables
Push-Down Accounting 162
Summary of Key Concepts 163
Key Terms 163
162
APPENDIX 4A
Push-Down Accounting Illustrated
Questions 166
Cases 166
Exercises 168
Problems 179
163
Chapter 5
Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book
Value 189
Walmart Acquires a Controlling Interest in Massmart 189
A Noncontrolling Interest in Conjunction with a Differential 190
Consolidated Balance Sheet with Majority-Owned Subsidiary 190
Consolidated Financial Statements with a Majority-Owned Subsidiary
193
Initial Year of Ownership 193
Second Year of Ownership 197
Discontinuance of Consolidation 200
Treatment of Other Comprehensive Income
203
Modification of the Consolidation Worksheet 203
Adjusting Entry Recorded by Subsidiary 203
Adjusting Entry Recorded by Parent Company 204
Consolidation Worksheet—Second Year Following Combination 204
Consolidation Procedures 204
Consolidation Worksheet—Comprehensive Income in Subsequent Years
207
Summary of Key Concepts
Key Terms 208
207
page xxv
APPENDIX 5A
Additional Consolidation Details
Questions 210
Cases 210
Exercises 212
Problems 221
208
Chapter 6
Intercompany Inventory Transactions
236
Inventory Transfers at Samsung Electronics 236
Overview of the Consolidated Entity and Intercompany Transactions
Elimination of Intercompany Transfers 238
Elimination of Unrealized Profits and Losses
Inventory Transactions
237
238
239
Worksheet Consolidation Entries 239
Transfers at Cost 239
Transfers at a Profit or Loss 239
Calculating Unrealized Profit or Loss 240
Deferring Unrealized Profit or Loss on the Parent’s Books 243
Deferring Unrealized Profit or Loss in the Consolidation 244
Why Adjust the Parent’s Books and Make Worksheet Entries? 246
Downstream Inventory Sale
Year 1
Year 2
246
246
252
Upstream Inventory Sale 256
Additional Considerations 263
Sale from One Subsidiary to Another 263
Sales and Purchases before Affiliation 263
Summary of Key Concepts
Key Terms 264
264
APPENDIX 6A
Intercompany Inventory Transactions—Modified Equity Method and Cost Method
Questions 273
Cases 274
Exercises 275
Problems 283
Chapter 7
Intercompany Transfers of Services and Noncurrent Assets
298
264
Micron’s Intercompany Fixed Asset Sale 298
Intercompany Transfers of Services 299
Intercompany Long-Term Asset Transfers 300
Intercompany Land Transfers 301
Overview of the Profit Consolidation Process 301
Assignment of Unrealized Profit Consolidation 303
Downstream Land Sale — Comprehensive Three-Year Example
Year 1—Downstream Land Sale 305
Year 2—Subsidiary Holds Land 311
Year 3—Land Sold to Nonafilliated Party 313
Upstream Sale of Land (Year of Sale) 317
Intercompany Transfers of Depreciable Assets
Downstream Sale 322
Change in Estimated Life of Asset upon Transfer
Upstream Sale 331
Asset Transfers before Year-End 340
Intercompany Transfers of Amortizable Assets
Summary of Key Concepts 342
Key Terms 342
305
322
331
342
APPENDIX 7A
Intercompany Noncurrent Asset Transactions—Modified Equity Method and Cost Method
Questions 351
Cases 352
Exercises 354
Problems 361
Chapter 8
Intercompany Indebtedness
374
Caesars Entertainment Corporation’s Debt Transfers
Consolidation Overview 375
Bond Sale Directly to an Affiliate 376
Transfer at Par Value 376
Transfer at a Discount or Premium
342
374
377
Bonds of Affiliate Purchased from a Nonaffiliate
379
Purchase at Book Value 380
Purchase at an Amount Less than Book Value 380
Purchase at an Amount Higher than Book Value 392
Summary of Key Concepts
Key Terms 395
394
APPENDIX 8A
Intercompany Indebtedness—Fully Adjusted Equity Method Using Straight-Line Interest Amortization
395
APPENDIX 8B
Intercompany Indebtedness—Modified Equity Method and Cost Method
410
Questions 418
Cases 419
Exercises 420
Problems 428
Chapter 9
Consolidation Ownership Issues
452
Berkshire Hathaway’s Varied Investments 452
Subsidiary Preferred Stock Outstanding 453
Consolidation with Subsidiary Preferred Stock Outstanding
453
page xxvi
Subsidiary Preferred Stock Held by Parent 456
Subsidiary Preferred Stock with Special Provisions 458
Illustration of Subsidiary Preferred Stock with Special Features
Changes in Parent Company Ownership
460
Parent’s Purchase of Additional Shares from Nonaffiliate 461
Parent’s Sale of Subsidiary Shares to Nonaffiliate 463
Subsidiary’s Sale of Additional Shares to Nonaffiliate 465
Subsidiary’s Sale of Additional Shares to Parent 468
Subsidiary’s Purchase of Shares from Nonaffiliate 470
Subsidiary’s Purchase of Shares from Parent 472
Complex Ownership Structures
474
Multilevel Ownership and Control 474
Reciprocal or Mutual Ownership 478
Subsidiary Stock Dividends
482
Illustration of Subsidiary Stock Dividends
Impact on Subsequent Periods 484
Summary of Key Concepts
Key Terms 486
Questions 486
Cases 487
Exercises 488
Problems 495
483
485
Chapter 10
Additional Consolidation Reporting Issues
Advanced Consolidation Issues at Alphabet 503
Consolidated Statement of Cash Flows 504
Preparation of a Consolidated Cash Flow Statement 504
Consolidated Cash Flow Statement Illustrated 504
Consolidated Cash Flow Statement—Direct Method 506
Consolidation Following an Interim Acquisition
Parent Company Entries
509
507
503
458
Consolidation Worksheet
510
Consolidation Income Tax Issues
512
Allocating the Basis of Assets Acquired in a Business Combination 512
Tax Allocation Procedures When Separate Tax Returns are Filed 516
Tax Effects of Unrealized Intercompany Profit Eliminations 519
Consolidated Earnings Per Share
523
Computation of Diluted Consolidated Earnings per Share 523
Computation of Consolidated Earnings per Share Illustrated 524
Summary of Key Concepts
Key Terms 527
Questions 527
Cases 528
Exercises 529
Problems 535
526
Chapter 11
Multinational Accounting: Foreign Currency Transactions and Financial Instruments
548
Microsoft’s Multinational Business 548
Doing Business in a Global Market 549
The Accounting Issues 550
Foreign Currency Exchange Rates 551
The Determination of Exchange Rates
Direct versus Indirect Exchange Rates
Changes in Exchange Rates 553
Spot Rates versus Current Rates 556
Forward Exchange Rates 556
Foreign Currency Transactions
551
551
556
Foreign Currency Import and Export Transactions
558
Managing International Currency Risk with Foreign Currency Forward Exchange Financial Instruments
562
Derivatives Designated as Hedges 562
Forward Exchange Contracts 566
Case 1: Managing an Exposed Foreign Currency Net Asset or Liability Position: Not a Designated Hedging
Instrument 567
Case 2: Hedging an Unrecognized Foreign Currency Firm Commitment: A Foreign Currency Fair Value Hedge
573
Case 3: Hedging a Forecasted Foreign Currency Transaction: A Foreign Currency Cash Flow Hedge 577
Case 4: Speculation in Foreign Currency Markets 580
Foreign Exchange Matrix 582
Additional Considerations
582
A Note on Measuring Hedge Effectiveness 582
Interperiod Tax Allocation for Foreign Currency Gains (Losses)
Hedges of a Net Investment in a Foreign Entity 583
Summary of Key Concepts
Key Terms 584
APPENDIX 11A
583
583
Illustration of Valuing Forward Exchange Contracts with Recognition for the Time Value of Money
584
APPENDIX 11B
Use of Other Financial Instruments by Multinational Companies
Questions 599
Cases 599
587
page xxvii
Exercises 601
Problems 612
Roger CPA Review
620
Chapter 12
Multinational Accounting: Issues in Financial Reporting and Translation of Foreign
Entity Statements 621
MCDonald’s—The World’s Fast Food Favorite 621
Convergence of Accounting Principles 623
Accounting for Differences in Currencies and Exchange Rates
Currency Definitions
624
624
Determination of the Functional Currency
625
Functional Currency Designation in Highly Inflationary Economies
627
Translation versus Remeasurement of Foreign Financial Statements 628
Translation of Functional Currency Statements into the Reporting Currency of the U.S. Company
Financial Statement Presentation of Translation Adjustment 631
Illustration of Translation and Consolidation of a Foreign Subsidiary
Noncontrolling Interest of a Foreign Subsidiary 641
Remeasurement of the Books of Record into the Functional Currency
631
643
Statement Presentation of Remeasurement Gain or Loss 645
Illustration of Remeasurement of a Foreign Subsidiary 645
Proof of Remeasurement Exchange Gain 646
Remeasurement Case: Subsequent Consolidation Worksheet 648
Summary of Translation versus Remeasurement 650
Additional Considerations in Accounting for Foreign Operations and Entities
Foreign Investments and Unconsolidated Subsidiaries 651
Liquidation of a Foreign Investment
652
Hedge of a Net Investment in a Foreign Subsidiary
Disclosure Requirements 653
652
Statement of Cash Flows 653
Lower-of-Cost-or-Market Inventory Valuation under Remeasurement 654
Intercompany Transactions 654
Income Taxes 656
Translation When a Third Currency is the Functional Currency 656
Summary of Key Concepts
Key Terms 657
Questions 657
657
651
630
Cases 658
Exercises 662
Problems 672
Roger CPA Review
682
Chapter 13
683
Segment and Interim Reporting
Segment Reporting at Walmart 683
Reporting for Segments 684
Segment Reporting Accounting Issues
683
684
International Financial Reporting Standards for Operating Segments
Information about Operating Segments
684
685
Defining Reportable Segments 685
Comprehensive Disclosure Test 691
Reporting Segment Information 692
Enterprisewide Disclosures
693
Information about Products and Services 693
Information about Geographic Areas 694
Information about Major Customers 695
Interim Financial Reporting 695
The Format of the Quarterly Financial Report
Accounting Issues 696
695
Accounting Pronouncements on Interim Reporting 696
International Financial Reporting Standards for Interim Reporting
Reporting Standards for Interim Income Statements
697
697
Revenue 697
Cost of Goods Sold and Inventory 698
All Other Costs and Expenses 701
Accounting for Income Taxes in Interim Periods 703
Disposal of a Component of the Entity or Unusual, Infrequently Occurring, and Contingent Items
Accounting Changes in Interim Periods
707
Change in an Accounting Principle (Retrospective Application) 707
Change in an Accounting Estimate (Current and Prospective Application) 708
Changes in Depreciation, Amortization, or Depletion 708
Change in a Reporting Entity (Retrospective Application) 708
International Financial Reporting Standards for Accounting Changes 709
Summary of Key Concepts
Key Terms 709
Questions 709
Cases 710
Exercises 714
Problems 723
Chapter 14
SEC Reporting
730
709
707
The Genesis of Securities Regulation
730
page xxviii
International Harmonization of Accounting Standards for Public Offerings
Securities and Exchange Commission 732
Organizational Structure of the Commission
Laws Administered by the SEC 733
The Regulatory Structure 733
732
Issuing Securities: The Registration Process
735
The Registration Statement 737
SEC Review and Public Offering 737
Accountants’ Legal Liability in the Registration Process
Periodic Reporting Requirements
731
738
738
Accountants’ Legal Liability in Periodic Reporting
741
Electronic Data Gathering, Analysis, and Retrieval (Edgar) System
Foreign Corrupt Practices Act of 1977 741
Sarbanes-Oxley Act of 2002 742
741
Title I: Public Company Accounting Oversight Board 742
Title II: Auditor Independence 743
Title III: Corporate Responsibility 743
Title IV: Enhanced Financial Disclosures 743
Title V: Analyst Conflicts of Interest 744
Title VI: Commission Resources and Authority 744
Title VII: Studies and Reports 744
Title VIII: Corporate and Criminal Fraud Accountability 744
Title IX: White-Collar Crime Penalty Enhancements 744
Title X: Sense of Congress Regarding Corporate Tax Returns 744
Title XI: Corporate Fraud and Accountability 745
Dodd-Frank Wall Street Reform and Consumer Protection Act
Jumpstart Our Business Startups (Jobs) Act 745
Disclosure Requirements 746
Management Discussion and Analysis
Pro Forma Disclosures 747
Summary of Key Concepts
Key Terms 748
Questions 748
Cases 749
Exercises 752
745
746
747
Chapter 15
Partnerships: Formation, Operation, and Changes in Membership
The Evolution of PricewaterhouseCoopers (PwC)
The Nature of the Partnership Entity 759
Legal Regulation of Partnerships 759
Definition of a Partnership 760
758
758
Formation of a Partnership 760
Other Major Characteristics of Partnerships 760
Accounting and Financial Reporting Requirements for Partnerships 763
International Financial Reporting Standards for Small and Medium-Size Entities and Joint Ventures
Accounting for the Formation of a Partnership
764
Illustration of Accounting for Partnership Formation
Accounting for the Operations of a Partnership
Partners’ Accounts
764
765
766
Allocating Profit or Loss to Partners
767
Illustrations of Profit Allocation 768
Multiple Profit Allocation Bases 771
Special Profit Allocation Methods 772
Partnership Financial Statements
Changes in Membership 772
772
General Concepts to Account for a Change in Membership in the Partnership 773
New Partner Purchases Partnership Interest Directly from an Existing Partner 774
New Partner Invests in Partnership 777
Determining a New Partner’s Investment Cost 789
Disassociation of a Partner from the Partnership 790
Summary of Key Concepts
Key Terms 793
792
APPENDIX 15A
Tax Aspects of a Partnership
793
APPENDIX 15B
Joint Ventures 794
Questions 796
Cases 797
Exercises 798
Problems 804
Chapter 16
Partnerships: Liquidation
811
The Demise of Laventhol & Horwath 811
Overview of Partnership Liquidations 812
Disassociation, Dissolution, Winding-Up, and Liquidation of a Partnership
Lump-Sum Liquidations
814
Realization of Assets 814
Liquidation Expenses 814
Illustration of a Lump-Sum Liquidation
Installment Liquidations
819
Illustration of Installment Liquidation
Cash Distribution Plan 823
Additional Considerations
826
Incorporation of a Partnership
Summary of Key Concepts
814
827
826
820
812
763
Key Terms
828
APPENDIX 16A
Partners’ Personal Financial Statements
828
page xxix
Questions 831
Cases 832
Exercises 833
Problems 843
Chapter 17
Governmental Entities: Introduction and General Fund Accounting
Accounting for the Bustling City of San Diego 849
Differences between Governmental and Private Sector Accounting
History of Governmental Accounting 851
Major Concepts of Governmental Accounting 852
Elements of Financial Statements 852
Expendability of Resources versus Capital Maintenance Objectives
Definitions and Types of Funds 853
Financial Reporting of Governmental Entities
850
853
856
Fund-Based Financial Statements: Governmental Funds
Measurement Focus and Basis of Accounting (MFBA)
856
859
Basis of Accounting—Governmental Funds 860
Basis of Accounting—Proprietary Funds 863
Basis of Accounting—Fiduciary Funds 863
Budgetary Aspects of Governmental Operations
Recording the Operating Budget
Accounting for Expenditures
864
864
865
The Expenditure Process 865
Classification of Expenditure Transactions and Accounts 867
Outstanding Encumbrances at the End of the Fiscal Period 868
Expenditures for Inventory 871
Accounting for Fixed Assets 873
Long-Term Debt and Capital Leases 874
Investments 875
Interfund Activities
875
(1) Interfund Loans 875
(2) Interfund Services Provided and Used
(3) Interfund Transfers 877
(4) Interfund Reimbursements 877
876
Overview of Accounting and Financial Reporting for the General Fund
Comprehensive Illustration of Accounting for the General Fund 878
Adoption of the Budget 878
Property Tax Levy and Collection
Other Revenue 881
880
878
849
Expenditures 882
Acquisition of Capital Asset 882
Interfund Activities 883
Adjusting Entries 883
Closing Entries 884
General Fund Financial Statement Information
Summary of Key Concepts
Key Terms 888
Questions 889
Cases 889
Exercises 891
Problems 899
885
888
Chapter 18
Governmental Entities: Special Funds and Governmentwide Financial Statements
907
Governmental Accounting in Maryland 907
Summary of Governmental Fund Types 908
Governmental Funds Worksheets 909
Special Revenue Funds 913
Capital Projects Funds 913
Illustration of Transactions 914
Financial Statement Information for the Capital Projects Fund
Debt Service Funds
916
Illustration of Transactions 917
Financial Statement Information for the Debt Service Fund
Permanent Funds
920
Illustration of Transactions
920
Governmental Funds Financial Statements
Enterprise Funds 924
921
Illustration of Transactions 924
Financial Statements for the Proprietary Funds
Internal Service Funds
932
932
Illustration of Private-Purpose Trust Fund
Agency Funds
927
930
Illustration of Transactions 930
Financial Statements for Internal Service Funds
Trust Funds
916
933
934
Illustration of Transactions in an Agency Fund
The Government Reporting Model
935
Four Major Issues 935
Government Financial Reports 937
Governmentwide Financial Statements 938
Reconciliation Schedules 942
Budgetary Comparison Schedule 943
Management’s Discussion and Analysis 944
934
919
Notes to the Governmentwide Financial Statements
Other Financial Report Items 945
Interim Reporting 945
Auditing Governmental Entities 946
Additional Considerations
944
946
Special-Purpose Governmental Entities
Summary of Key Concepts
Key Terms 947
946
947
APPENDIX 18A
Other Governmental Entities—Public School Systems and the Federal Government
947
page xxx
Questions 949
Cases 950
Exercises 951
Problems 963
Chapter 19
973
Not-for-Profit Entities
973
United Way Worldwide 973
Financial Reporting for Private, Not-For-Profit Entities
Additional Standards for Not-for-Profit Entities
Colleges and Universities
974
976
978
Special Conventions of Revenue and Expenditure Recognition
Board-Designated Funds 979
Public Colleges and Universities 979
Private Colleges and Universities
Health Care Providers
978
979
982
Hospital Accounting 983
Financial Statements for a Not-for-Profit Hospital 986
Comprehensive Illustration of Hospital Accounting and Financial Reporting
Summary of Hospital Accounting and Financial Reporting 1001
Voluntary Health and Welfare Organizations
1001
Accounting for a VHWO 1001
Financial Statements for a VHWO 1002
Summary of Accounting and Financial Reporting for VHWOs
Other Not-for-Profit Entities
1012
Accounting for an ONPO 1012
Financial Statements of an ONPO 1012
Summary of Accounting and Financial Reporting for an ONPO
Summary of Key Concepts
Key Terms 1016
Questions 1016
Cases 1017
1010
1015
1014
990
Exercises
Problems
1020
1030
Chapter 20
1043
Corporations in Financial Difficulty
GM in Financial Distress 1043
Courses of Action 1045
Nonjudicial Actions 1045
Judicial Actions 1046
Chapter 11 Reorganizations
1047
Fresh Start Accounting 1049
Plan of Reorganization 1050
Illustration of a Reorganization
1050
Chapter 7 Liquidations 1058
Classes of Creditors 1058
Secured Creditors 1058
Creditors with Priority 1058
General Unsecured Creditors 1060
Statement of Affairs 1060
Additional Considerations
1061
Trustee Accounting and Reporting
Summary of Key Concepts
Key Terms 1067
Questions 1067
Cases 1067
Exercises 1069
Problems 1072
INDEX
1077
1066
1061
1043
page 1
1
Intercorporate Acquisitions and
Investments in Other Entities
Multicorporate Entities
Business Combinations
Consolidation Concepts and Procedures
Intercompany Transfers
Additional Consolidation Issues
Multinational Entities
Reporting Requirements
Partnerships
Governmental and Not-for-Profit Entities
Corporations in Financial Difficulty
MICROSOFT’S ACQUISITION OF LINKEDIN
In recent years, as well as during the past several decades, the business world has witnessed many corporate acquisitions and combinations, often involving
some of the world’s largest and best-known companies. Some of these combinations have captured public attention because of the personalities involved, the
daring strategies employed, and the huge sums of money at stake. On June 13, 2016, Microsoft Corp. announced the acquisition of LinkedIn for $26.2
billion. Although the software giant, Microsoft, has grown through acquisitions in the past, the LinkedIn acquisition represents the largest in Microsoft’s
history.
LinkedIn began as a startup Internet-based social media website for connecting business professionals in December of 2002. The company grew rapidly,
reaching a million users by August of 2004. LinkedIn went public in 2011 in a well-publicized IPO. The company continued to grow through many
acquisitions of its own until the agreement was reached in 2016 that it would be acquired by Microsoft.
LinkedIn’s acquisition by Microsoft was the result of amicable negotiations between the two companies and the deal was unanimously approved by both
boards. According to Microsoft’s website, the agreement was reached with enthusiasm from both sides.
“The LinkedIn team has grown a fantastic business centered on connecting the world’s professionals,” Microsoft’s CEO, Satya Nadella said. “Together
we can accelerate the growth of LinkedIn, as well as Microsoft Office 365 and Dynamics as we seek to empower every person and organization on the
planet.”
"Just as we have changed the way the world connects to opportunity, this relationship with Microsoft, and the combination of their cloud and LinkedIn’s
network, now gives us a chance to also change the way the world works,” LinkedIn’s founder and CEO, Jeff Weiner, said. “For the last 13 years, we’ve
been uniquely positioned to connect professionals to make them more productive and successful, and I’m looking forward to leading our team through the
next chapter of our story.”
Microsoft financed the all-cash deal by issuing new debt and the acquisition was completed in December of 2016.
The business world is complex and frequent business combinations will continue to increase the complexity of the business environment in the future. An
understanding of the accounting treatment of mergers, acquisitions, and other intercorporate investments is an invaluable asset in our ever-changing markets.
This chapter introduces the key concepts associated with business combinations.
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO 1–1
Understand and explain the reasons for and different methods of business expansion, the types of organizational structures, and the types
of acquisitions.
LO 1–2
Understand the development of standards related to acquisition accounting over time.
page 2
LO 1–3
Make calculations and prepare journal entries for the creation of a business entity.
LO 1–4
Understand and explain the differences between different forms of business combinations.
LO 1–5
Make calculations and business combination journal entries in the presence of a differential, goodwill, or a bargain purchase element.
LO 1–6
Understand additional considerations associated with business combinations.
AN INTRODUCTION TO COMPLEX BUSINESS STRUCTURES
L O 1 –1
Understand and explain the reasons for and different methods of business expansion, the types of organizational structures, and the types of
acquisitions.
The business environment in the United States is perhaps the most dynamic and vibrant in the world, characterized by rapid change and exceptional
complexity. In this environment, regulators and standard setters such as the Securities and Exchange Commission (SEC), the Financial Accounting Standards
Board (FASB), and the Public Company Accounting Oversight Board (PCAOB) are working to keep pace with a rapidly-changing world in order to ensure
the continued usefulness of accounting reports so that they continue to accurately reflect economic reality. A number of accounting and reporting issues arise
when two or more companies join under common ownership or a company creates a complex organizational structure involving new financing or operating
entities. The first 10 chapters of this text focus on a number of these issues. Chapter 1 lays the foundation by describing some of the factors that have led to
corporate expansion and some of the types of complex organizational structures and relationships that have evolved. Then it describes the accounting and
reporting issues related to formal business combinations. Chapter 2 focuses on investments in the common stock of other companies. It also introduces
basic concepts associated with the preparation of consolidated financial statements that portray the related companies as if they were actually a single entity.
The next eight chapters systematically explain additional details related to the preparation and use of consolidated financial statements.
Enterprise Expansion
Most business enterprises seek to expand over time in order to survive and become profitable. Both the owners and managers of a business enterprise have
an interest in seeing a company grow in size. Increased size often allows economies of scale in both production and distribution. By expanding into new
markets or acquiring other companies already in those markets, companies can develop new earning potential and those in cyclical industries can add greater
stability to earnings through diversification. For example, in 1997, Boeing, a company very strong in commercial aviation, acquired McDonnell Douglas, a
company weak in commercial aviation but very strong in military aviation and other defense and space applications. In the early 2000s when orders for
commercial airliners plummeted following a precipitous decline in air travel, increased defense spending helped level out Boeing’s earnings.
Business Objectives
Complex organizational structures often evolve to help achieve a business’s objectives, such as increasing profitability or reducing risk. For example, many
companies establish subsidiaries to conduct certain business activities. A subsidiary is a corporation that another corporation, referred to as a parent
company, controls, usually through majority ownership of its common stock. Because a subsidiary is a separate legal entity, the parent’s risk associated with
the subsidiary’s activities is limited. There are many reasons for creating or acquiring a subsidiary. For example, companies often transfer their receivables to
subsidiaries or special-purpose entities that use the receivables as collateral for bonds issued to other entities (securitization). External parties may hold partial
or complete ownership of those entities, allowing the transferring company (i.e., the parent that originally held the receivables) to share its risk associated
with the receivables. In some situations, companies can realize tax benefits by conducting certain activities through a separate entity. Bank of page 3
America, for example, established a subsidiary to which it transferred bank-originated loans and was able to save $418 million in quarterly taxes. 1
Frequency of Business Combinations
Very few major companies function as single legal entities in our modern business environment. Virtually all major companies have at least one subsidiary,
with more than a few broadly diversified companies having several hundred subsidiaries. In some cases, subsidiaries are created internally to separately
incorporate part of the ongoing operations previously conducted within the parent company. Other subsidiaries are acquired externally through business
combinations.
Business combinations are a continuing and frequent part of the business environment. For example, a merger boom occurred in the 1960s. This period
was characterized by frantic and, in some cases, disorganized merger binges, resulting in creation of a large number of conglomerates, or companies
operating in many different industries. Because many of the resulting companies lacked coherence in their operations, they often were less successful than
anticipated, and many of the acquisitions of the 1960s have since been sold or abandoned. In the 1980s, the number of business combinations again
increased. That period saw many leveraged buyouts or LBOs (when an acquiring company borrows the funds to buy another company), but the resulting
debt plagued many of those companies for many years.
Through much of the 1990s, merger activity was fueled by a new phenomenon, the use of private equity money. Rather than the traditional merger
activity that typically involves one publicly held company acquiring another, groups of investors—such as wealthy individuals, pension and endowment
funds, and mutual funds—pooled their money to make acquisitions. Most of these acquisitions did not result in lasting ownership relationships, with the
private equity companies usually attempting to realize a return by selling their investments after a relatively short holding period.
The number of business combinations through the 1990s dwarfed previous merger booms, with all records for merger activity shattered. This pace
continued into the new century, with a record-setting $3.3 trillion in deals closed in 2000. 2 However, with the downturn in the economy in the early 2000s,
the number of mergers declined significantly. Many companies put their expansion plans on hold, and a number of the mergers that did occur were aimed at
survival.
Toward the middle of 2003, merger activity again increased and accelerated significantly through the middle of the decade. During one period of less than
100 hours in 2006, “around $110 billion in acquisition deals were sealed worldwide in sectors ranging from natural gas, to copper, to mouthwash to steel,
linking investors and industrialists from India, to Canada, to Luxembourg to the U.S.”3
FYI
Historically, mergers have come in waves as indicated by the following summary:
Period
Name
Facet
1893–1904
First Wave
Horizontal mergers
1919–1929
Second Wave
Vertical mergers
1955–1970
Third Wave
Diversified conglomerate mergers
1974–1989
Fourth Wave
Congeneric mergers; hostile takeovers; corporate raiding, LBOs
1993–2000
Fifth Wave
Cross-border mergers
2003–2008
Sixth Wave
Shareholder activism, private equity, LBOs
2011–Present
Seventh Wave
Global expansion
Sources: Martin Lipton, “Merger Waves in the 19th, 20th and 21st Centuries,” The Davies Lecture, York University,
September 14, 2006.” Michael J. De La Merced and Jeffrey Cane, “Confident Deal Makers Pulled Out Checkbooks in 2010,”
The New York Times, January 3, 2011; Anastasia, “A Historical Analysis of M&A Waves,” Cleverism.com, January 26, 2016.
page 4
This activity was slowed dramatically by the credit crunch of 2007–2008. Nevertheless, business combinations have increased dramatically in the
postcrisis period and will continue to be an important business activity as global expansion progresses.
Aside from private equity acquisitions, business combinations have been common in telecommunications, defense, banking and financial services,
information technology, energy and natural resources, entertainment, pharmaceuticals, and manufacturing. Some of the world’s largest companies and bestknown names have been involved in recent major acquisitions, such as Microsoft, Time Warner, Kraft, Procter & Gamble, Gillette, Citigroup, Bank of
America, Whirlpool, Sprint, Verizon, Adobe Systems, Chrysler, BP, and ExxonMobil.
Ethical Considerations
Acquisitions can sometimes lead to ethical challenges for managers. Corporate managers are often rewarded with higher salaries as their companies increase
in size. In addition, prestige frequently increases with the size of a company and with a reputation for the successful acquisition of other companies. As a
result, corporate managers often find it personally advantageous to increase company size. For instance, Bernard Ebbers started his telecommunications
career as the head of a small discount long-distance telephone service company and built it into one of the world’s largest corporations, WorldCom. In the
process, Ebbers became well known for his acquisition prowess and grew tremendously wealthy—until WorldCom was racked by accounting scandals and
declared bankruptcy and Ebbers was sentenced to prison in 2003.
Acquisitions and complex organizational structures have sometimes been used to manipulate financial reporting with the aim of enhancing or enriching
managers. Many major corporations, taking advantage of loopholes or laxness in financial reporting requirements, have used subsidiaries or other entities to
borrow large amounts of money without reporting the debt on their balance sheets. Some companies have created special entities that have then been used to
manipulate profits.
The term special-purpose entity has become well known in recent years because of the egregious abuse of these entities by companies such as Enron. A
special-purpose entity (SPE) is, in general, a financing vehicle that is not a substantive operating entity, usually one created for a single specified purpose. An
SPE may be in the form of a corporation, trust, or partnership. Enron, one of the world’s largest companies prior to its collapse in 2001, established many
SPEs, at least some of which were intended to manipulate financial reporting. Some of Enron’s SPEs apparently were created primarily to hide debt, and
others were used to create fictional transactions or to convert borrowings into reported revenues. The FASB has since clarified the rules around the
accounting for SPEs to avoid this issue (which is discussed in more detail in Chapter 3).
Accounting for mergers and acquisitions is also an area that can lend itself to manipulation. Arthur Levitt, former chairman of the SEC, referred to some
of the accounting practices that have been used in accounting for mergers and acquisitions as “creative acquisition accounting” or “merger magic.” For
example, an approach used by many companies in accounting for their acquisitions was to assign a large portion of the purchase price of an acquired
company to its in-process research and development, immediately expensing the full amount and freeing financial reporting in future periods from the burden
of those costs. The FASB has since eliminated this practice.
The scandals and massive accounting failures at companies such as Enron, WorldCom, and Tyco—causing creditors, investors, employees, and others to
suffer heavy losses—focused considerable attention on weaknesses in accounting and the accounting profession. In the past several years, Congress, the
SEC, and the FASB have taken actions to strengthen the financial reporting process and to clarify the accounting rules relating to special entities
page 5
and to acquisitions. However, the frequency and size of business combinations, the complexity of accounting, and the potential impact on
financial statements of the accounting methods employed mean that the issues surrounding the accounting for business combinations are still of critical
importance.
BUSINESS EXPANSION AND FORMS OF ORGANIZATIONAL STRUCTURE
Historically, businesses have expanded by internal growth through new product development and expansion of existing product lines into new markets. In
recent decades, however, many companies have chosen to expand by combining with or acquiring other companies. Either approach may lead to a change in
organizational structure.
Internal Expansion: Creating a Business Entity
As companies expand from within, they often find it advantageous to conduct their expanded operations through new subsidiaries or other entities such as
partnerships, joint ventures, or special entities. In most of these situations, an identifiable segment of the company’s existing assets is transferred to the new
entity (Subsidiary), and in exchange, the transferring company (Parent) receives equity ownership.
Companies may be motivated to establish new subsidiaries or other entities for a variety of reasons. Broadly diversified companies may place unrelated
operations in separate subsidiaries to establish clear lines of control and facilitate the evaluation of operating results. In some cases, an entity that specializes
in a particular type of activity or has its operations in a particular country may qualify for special tax incentives. Of particular importance in some industries
is the fact that a separate legal entity may be permitted to operate in a regulatory environment without subjecting the entire entity to regulatory control. Also,
by creating a separate legal entity, a parent company may be able to protect itself from exposing the entire company’s assets to legal liability that may stem
from a new product line or entry into a higher-risk form of business activity.
Companies also might establish new subsidiaries or other entities, not as a means of expansion, but as a means of disposing of a portion of their existing
operations through outright sale or a transfer of ownership to existing shareholders or others. In some cases, companies have used this approach to dispose
of a segment of operations that no longer fits well with the overall mission of the company. In other cases, this approach has been used as a means of
disposing of unprofitable operations or to gain regulatory or shareholder approval of a proposed merger with another company. A spin-off occurs when the
ownership of a newly created or existing subsidiary is distributed to the parent’s stockholders without the stockholders surrendering any of their stock in the
parent company. Thus, the company divests itself of the subsidiary because it is owned by the company’s shareholders after the spin-off.
FYI
In July of 2015, eBay spun off PayPal, which it had owned since 2002, to help both businesses take
advantage of new growth opportunities.
page 6
A split-off occurs when the subsidiary’s shares are exchanged with some of P’s shareholders for their P Company shares, thereby leading to a reduction
in the parent company’s outstanding shares. Thus, some of the P shareholders will keep their P shares while others will trade them for S shares, essentially
dividing the original P shareholders. Although the two divestiture types are similar, the split-off could result in one set of the former parent shareholders
exchanging their shares for those of the divested subsidiary.
External Expansion: Business Combinations
Many times companies find that entry into new product areas or geographic regions is more easily accomplished by acquiring or combining with other
companies than through internal expansion. For example, SBC Communications, a major telecommunications company significantly increased its service area
by combining with Pacific Telesis and Ameritech, later acquiring AT&T (and adopting its name), and subsequently combining with BellSouth. Similarly,
because the state of Florida has traditionally been very reluctant to issue new bank charters, bank corporations wishing to establish operations in Florida have
had to acquire an existing bank to obtain a charter in the state.
page 7
A business can be defined as an organization or enterprise engaged in providing goods or services to customers. However, a business doesn’t necessarily
have to be a separate legal entity. A business combination occurs when “. . . an acquirer obtains control of one or more businesses.”4 The diagram on the
preceding page illustrates a typical acquisition. The concept of control relates to the ability to direct policies and management. Traditionally, control over a
company has been gained by acquiring a majority of the company’s common stock. However, the diversity of financial and operating arrangements employed
in recent years also raises the possibility of gaining control with less than majority ownership or, in some cases, with no ownership at all through other
contractual arrangements.
FYI
On April 2, 2012, Zynga Inc. purchased its previously leased corporate headquarters building located in
San Francisco, California, to support the overall growth of its business. In accordance with ASC 805,
“Business Combinations,” Zynga accounted for the building purchase as a business combination even though
it wasn’t a stand-alone legal entity because (it argued) the building met the definition of a business.
The types of business combinations found in today’s business environment and the terms of the combination agreements are as diverse as the firms
involved. Companies enter into various types of formal and informal arrangements that may have at least some of the characteristics of a business
combination. Most companies tend to avoid recording informal agreements on their books because of the potential difficulty of enforcing them. In fact, some
types of informal arrangements, such as those aimed at fixing prices or apportioning potential customers, are illegal. Formal agreements generally are
enforceable and are more likely to be recognized on the books of the participants.
Organizational Structure and Financial Reporting
When companies expand or change organizational structure by acquiring other companies or through internal division, the new structure must be examined
to determine the appropriate financial reporting procedures. Several approaches are possible, depending on the circumstances:
1. Merger A merger is a business combination in which the acquired business’s assets and liabilities are combined with those of the acquiring company. Thus, two
companies are merged into a single entity. In essence, the acquiring company “swallows” the acquired business. When the two companies merge, one of them
ceases to exist as a separate entity and the name of the acquiring company continues.
2. Controlling ownership A business combination in which the acquired company remains as a separate legal entity with a majority of its common stock owned by
the purchasing company leads to a parent–subsidiary relationship. Accounting standards normally require that the financial statements of the parent and
subsidiary be consolidated for general-purpose reporting so the companies appear as a single entity. The treatment is the same if the subsidiary is created rather
than purchased. The treatment is also the same when the other entity is unincorporated and the investor company has control and majority ownership.5
3. Noncontrolling ownership The purchase of a less-than-majority interest in another corporation does not usually result in a business combination or controlling
situation. A similar situation arises when a company creates another entity and holds less than a controlling position in it or purchases a less-than-controlling
interest in an existing partnership. In its financial statements, the investor company reports its interest in the investee as an investment with the specific method of
accounting (cost method, equity method, consolidation) dictated by the circumstances.
4. Other beneficial interest One company may have a beneficial interest in another entity even without a direct ownership interest. The beneficial interest may be
defined by the agreement establishing the entity or by an operating or financing agreement. When the beneficial interest is based on contractual page 8
arrangements instead of majority stock ownership, the reporting rules may be complex and depend on the circumstances. In general, a company that has
the ability to make decisions significantly affecting the results of another entity’s activities or is expected to receive a majority of the other entity’s profits and
losses is considered to be that entity’s primary beneficiary. Normally, that entity’s financial statements would be consolidated with those of the primary
beneficiary.
These different situations, and the related accounting and reporting procedures, are discussed throughout the first 10 chapters of the text. The primary focus
is on the first three situations, especially the purchase of all or part of another company’s stock. The discussion of the fourth situation in Chapter 3 is limited
because of its complexity and the diversity of these contractual arrangements.
THE DEVELOPMENT OF ACCOUNTING FOR BUSINESS COMBINATIONS
L O 1 –2
Understand the development of standards related to acquisition accounting over time.
For more than half a century, accounting for business combinations remained largely unchanged. Two methods of accounting for business combinations, the
purchase method and the pooling-of-interests method, were acceptable during that time. However, major changes in accounting for business combinations
have occurred over the past two decades. First, the FASB eliminated the pooling-of-interests method in 2001, leaving only a single method, purchase
accounting. Then, in 2007, the FASB issued the revised standard (ASC 805) that replaced the purchase method with the acquisition method, which is now
the only acceptable method of accounting for business combinations. The FASB continues to refine acquisition accounting, but it has not changed
fundamentally since 2007.
Although all business combinations must now be accounted for using the acquisition method, many companies’ financial statements will continue to
include the effects of previous business combinations recorded using the pooling-of-interests and purchase methods. Thus, a general understanding of these
methods can be helpful.
The idea behind a pooling of interests was that no change in ownership had actually occurred in the business combination, often a questionable premise.
Based on this idea, the book values of the combining companies were carried forward to the combined company and no revaluations to fair value were made.
Managers often preferred pooling accounting because it did not result in asset write-ups or goodwill that might burden future earnings with additional
depreciation or write-offs.
Purchase accounting treated the purchase of a business much like the purchase of any asset. The acquired company was recorded based on the purchase
price that the acquirer paid. Individual assets and liabilities of the acquired company were valued at their fair values, and the difference between the total
purchase price and the fair value of the net identifiable assets acquired was recorded as goodwill. All direct costs of bringing about and consummating the
combination were included in the total purchase price.
Acquisition accounting is consistent with the FASB’s intention to move accounting in general more toward recognizing fair values. Under acquisition
accounting, the acquirer in a business combination, in effect, values the acquired company based on the fair value of the consideration given in the
combination and the fair value of any noncontrolling interest not acquired by the acquirer.
ACCOUNTING FOR INTERNAL EXPANSION: CREATING BUSINESS ENTITIES 6
L O 1 –3
Make calculations and prepare journal entries for the creation of a business entity.
Companies that choose to conduct a portion of their operations through separate business entities usually do so through corporate subsidiaries, corporate
joint ventures, or partnerships. The ongoing accounting and reporting for investments in corporate joint ventures and subsidiaries are discussed in Chapters 2
through 10. This section discusses the origination of these entities when the parent or investor creates them rather than purchases an interest in an page 9
existing corporation or partnership.
When a company transfers assets or operations to another entity that it has created, a vast number of variations in the types of entities and the types of
agreements between the creating company and the created entity are possible. Accordingly, it is impossible to establish a single set of rules and procedures
that will suffice in all situations. We focus on the most straightforward and common cases in which the transferring company creates a subsidiary or
partnership that it owns and controls, including cases in which the company intends to transfer ownership to its stockholders through a spin-off or split-off.
In simple cases, the company transfers assets, and perhaps liabilities, to an entity that the company has created and controls and in which it holds majority
ownership. The company transfers assets and liabilities to the created entity at book value, and the transferring company recognizes an ownership interest in
the newly created entity equal to the book value of the net assets transferred. Recognition of fair values of the assets transferred in excess of their carrying
values on the books of the transferring company normally is not appropriate in the absence of an arm’s-length transaction. Thus, no gains or losses are
recognized on the transfer by the transferring company. However, if the value of an asset transferred to a newly created entity has been impaired prior to the
transfer and its fair value is less than the carrying value on the transferring company’s books, the transferring company should recognize an impairment loss
and transfer the asset to the new entity at the lower fair value.
FYI
An “arm’s-length transaction” is one in which the parties are completely independent of one another so
that they act in their personal best interests or to maximize their own wealth. Thus, there is no chance
of collusion between them.
The created entity begins accounting for the transferred assets and liabilities in the normal manner based on their book values at the time of transfer.
Subsequent financial reporting involves consolidating the created entity’s financial statements with those of the parent company. Overall, the consolidated
financial statements appear the same as if the transfer had not taken place.
As an illustration of a created entity, assume that Padre Company creates a subsidiary, Sonny Company, and transfers the following assets to Sonny in
exchange for all 100,000 shares of Sonny’s $2 par common stock:
Item
Cost
Cash
Book Value
$ 70,000
Inventory
$50,000
50,000
75,000
75,000
Building
100,000
80,000
Equipment
250,000
160,000
Land
$435,000
Padre records the transfer with the following entry:7
(1)
Investment in Sonny Company Common Stock
435,000
Accumulated Depreciation, Building
20,000
Accumulated Depreciation, Equipment
90,000
Cash
70,000
Inventory
50,000
Land
75,000
Building
100,000
Equipment
250,000
Record the creation of Sonny Company.
page 10
Sonny Company records the transfer of assets and the issuance of stock (at the book value of the assets) as follows:
(2)
Cash
70,000
Inventory
50,000
Land
75,000
Building
100,000
Equipment
250,000
Accumulated Depreciation, Building
20,000
Accumulated Depreciation, Equipment
90,000
Common Stock, $2 par
200,000
Additional Paid-In Capital
235,000
Record the receipt of assets and the issuance of $2 par common stock.
ACCOUNTING FOR EXTERNAL EXPANSION: BUSINESS COMBINATIONS
L O 1 –4
Understand and explain the differences between different forms of business combinations.
A business combination occurs when one party acquires control over one or more businesses. This usually involves two or more separate businesses being
joined together under common control. The acquirer may obtain control by paying cash, transferring other assets, issuing debt, or issuing stock. In rare
cases, the acquirer might obtain control by agreement or through other means without an exchange taking place. Business combinations can take one of
several different forms and can be effected in different ways.
Legal Forms of Business Combinations
Figure 1–1 illustrates the three primary legal forms of business combinations. A statutory merger is a type of business combination in which only one of the
combining companies survives and the other loses its separate identity. The acquired company’s assets and liabilities are transferred to the acquiring
company, and the acquired company is dissolved, or liquidated. The operations of the previously separate companies are carried on in a single legal entity
following the merger. Unlike other forms of business combination that must be stock-only transactions to be tax free, a statutory merger allows the acquiring
company to transfer stock and other assets to bail out dissenting shareholders.
A statutory consolidation is a business combination in which both combining companies are dissolved and the assets and liabilities of both companies are
transferred to a newly created corporation. The operations of the previously separate companies are carried on in a single legal entity, and neither of the
combining companies remains in existence after a statutory consolidation. In many situations, however, the resulting corporation is new in form only, and in
substance it actually is one of the combining companies reincorporated with a new name.
A stock acquisition occurs when one company acquires the voting shares of another company and the two companies continue to operate as separate,
but related, legal entities. Because neither of the combining companies is liquidated, the acquiring company accounts for its ownership interest in the other
company as an investment. In a stock acquisition, the acquiring company need not acquire all the other company’s stock to gain control. The relationship
that is created in a stock acquisition is referred to as a parent–subsidiary relationship. A parent company is one that controls another company, referred to as
a subsidiary, usually through majority ownership of common stock. For general-purpose financial reporting, a parent company and its subsidiaries present
consolidated financial statements that appear largely as if the companies had actually merged into one.
Sometimes a new corporation is created by two (or more) companies to become their common holding company, a special case of a stock acquisition.
Assuming the shareholders of the two companies approve of the creation of the new holding company, they will exchange their shares in the existing
companies for shares of the newly created holding company. The holding company becomes the parent company and the existing companies become the
subsidiaries.
page 11
F I G U R E 1 –1
Legal Forms of Business Combinations
The legal form of a business combination, the substance of the combination agreement, and the circumstances surrounding the combination all affect
how the combination is recorded initially and the accounting and reporting procedures used subsequent to the combination.
Methods of Effecting Business Combinations
Business combinations can be characterized as either friendly or unfriendly. In a friendly combination, the managements of the companies involved come to
an agreement on the terms of the combination and recommend approval by the stockholders. These combinations usually are effected in a single transaction
involving an exchange of assets or voting shares. In an unfriendly combination, or “hostile takeover,” the managements of the companies involved are unable
to agree on the terms of a combination, and the management of one of the companies makes a tender offer directly to the shareholders of the other company
to buy their stock at a specified price. A tender offer invites the shareholders of the other company to “tender,” or exchange, their shares for securities or
assets of the acquiring company. If sufficient shares are tendered, the acquiring company gains voting control of the other company and can install its own
management by exercising its voting rights.
The specific procedures to be used in accounting for a business combination depend on whether the combination is effected through an acquisition of
assets or an acquisition of stock.
page 12
Acquisition of Assets
Sometimes one company acquires another company’s assets through direct negotiations with its management. The agreement also may involve the acquiring
company assuming the other company’s liabilities. Combinations of this sort normally take form (a) or form (b) in Figure 1–1. The selling company generally
distributes to its stockholders the assets or securities received in the combination from the acquiring company and liquidates, leaving only the acquiring
company as the surviving legal entity.
The acquiring company accounts for the combination by recording each asset acquired, each liability assumed, and the consideration given in exchange at
fair value.
STOP & THINK
Can you name the 10 largest and best-known North American merger and acquisition transactions? They’ve
all happened in your lifetime!
Source: Institute of Mergers, Acquisitions and Alliances.
Acquisition of Stock
A business combination effected through a stock acquisition does not necessarily have to involve the acquisition of all of a company’s outstanding voting
shares. For one company to gain control over another through stock ownership, a majority (i.e., more than 50 percent) of the outstanding voting shares
usually is required unless other factors lead to the acquirer gaining control. The total of the shares of an acquired company not held by the controlling
shareholder is called the noncontrolling interest. In the past, the noncontrolling interest was referred to as the minority interest.
In those cases when control of another company is acquired and both companies remain in existence as separate legal entities following the business
combination, the investment in the stock of the acquired company is recorded on the books of the acquiring company as an asset.
Valuation of Business Entities
All parties involved in a business combination must believe they have an opportunity to benefit before they will agree to participate. Determining whether a
particular combination proposal is advantageous can be difficult. Both the value of a company’s assets and its future earning potential are important in
assessing the value of the company. Tax laws also influence investment decisions. For example, the existence of accumulated net operating losses that can be
used under U.S. tax law to shelter future income from taxes increases the value of a potential acquiree.
Value of Individual Assets and Liabilities
The value of a company’s individual assets and liabilities is usually determined by appraisal. For some items, the value may be determined with relative ease,
such as investments that are traded actively in the securities markets or short-term receivables or payables. For other items, the appraisal may be much more
subjective, such as the value of land located in an area where few recent sales have occurred. In addition, certain intangibles typically are not reported on the
balance sheet. For example, the costs of developing new ideas, new products, and new production methods normally are expensed as research and
development costs in the period incurred.
Current liabilities are often viewed as having fair values equal to their book values because they will be paid at face amount within a short time. Long-term
liabilities, however, must be valued based on current interest rates if different from the effective rates at the issue dates of the liabilities. For
page 13
example, if $100,000 of 10-year, 6 percent bonds, paying interest annually, had been issued at par three years ago, and the current market rate
of interest for the same type of security is 10 percent, the value of the liability currently is computed as follows:
Present value for 7 years at 10% of principal payment of $100,000
Present value at 10% of 7 interest payments of $6,000
Present value of bond
$51,316
29,211
$80,527
Although accurate assessments of the value of assets and liabilities may be difficult, they form an important part of the overall determination of the value
of an enterprise.
Value of Potential Earnings
In many cases, assets operated together as a group have a value that exceeds the sum of their individual values (i.e., there is unrecorded goodwill). This
“going-concern value” makes it desirable to operate the assets as an ongoing entity rather than sell them individually. A company’s earning power as an
ongoing enterprise is of obvious importance in valuing that company.
There are different approaches to measuring the value of a company’s future earnings. Sometimes companies are valued based on a multiple of their
current earnings. For example, if Bargain Company reports earnings of $35,000 for the current year, the company’s value based on a multiple of 10 times
current earnings is $350,000. The appropriate multiple to use is a matter of judgment and is based on factors such as the riskiness and variability of the
earnings and the anticipated degree of growth.
Another method of valuing a company is to compute the present value of the anticipated future net cash flows generated by the company. This approach
requires the assessment of the amount and timing of future cash flows and discounting them back to the present value at the discount rate determined to be
appropriate for the type of enterprise. For example, if Bargain Company is expected to generate cash flows of $35,000 for each of the next 25 years, the
present value of the firm at a discount rate of 10 percent is $317,696. Estimating the potential for future earnings requires numerous assumptions and
estimates. Not surprisingly, the buyer and seller often have difficulty agreeing on the value of a company’s expected earnings.
Valuation of Consideration Exchanged
When one company acquires another, the acquiring company must place a value on the consideration given in the exchange. Little difficulty is encountered
when the acquiring company gives cash in an acquisition, but valuation may be more difficult when the acquiring company gives securities, particularly new
untraded securities or securities with unusual features. For example, General Motors completed an acquisition a number of years ago by issuing a new Series
B common stock that paid dividends based on subsequent earnings of the acquired company rather than on the earnings of General Motors as a whole. Some
companies have issued non-interest-bearing bonds (zero coupon bonds), which have a fair value sufficiently below par value to compensate the holder for
interest. Other companies have issued various types of convertible securities. Unless these securities, or others that are considered equivalent, are being
traded in the market, estimates of their value must be made. The approach generally followed is to use the value of some similar security with a determinable
market value and adjust for the estimated value of the differences in the features of the two securities.
page 14
ACQUISITION ACCOUNTING
Current standards require the use of the acquisition method of accounting for business combinations. Under the acquisition method, the acquirer recognizes
all assets acquired and liabilities assumed in a business combination and measures them at their acquisition-date fair values. If less than 100 percent of the
acquiree is acquired, the noncontrolling interest also is measured at its acquisition-date fair value. If the acquiring company already had an ownership interest
in the acquiree, that investment is also measured at its acquisition-date fair value. Note that a business combination does not affect the amounts at which the
other assets and liabilities of the acquirer are valued.
L O 1 –5
Make calculations and business combination journal entries in the presence of a differential, goodwill, or a bargain purchase element.
Fair Value Measurements
Because accounting for business combinations is now based on fair values, the measurement of fair values takes on added importance. The acquirer must
value at fair value (1) the consideration it exchanges in a business combination, (2) each of the individual identifiable assets and liabilities acquired, (3) any
noncontrolling interest in the acquiree, and (4) any interest already held in the acquiree. Normally, a business combination involves an arm’s-length exchange
between two unrelated parties. The value of the consideration given in the exchange is usually the best measure of the value received and, therefore, reflects
the value of the acquirer’s interest in the acquiree. 8
Applying the Acquisition Method
For all business combinations, an acquirer must be identified, and that party is the one gaining control over the other. In addition, an acquisition date must be
determined. That date is usually the closing date when the exchange transaction actually occurs. However, in rare cases control may be acquired on a
different date or without an exchange, so the circumstances must be examined to determine precisely when the acquirer gains control.
Under the acquisition method, the full acquisition-date fair values of the individual assets acquired, both tangible and intangible, and liabilities assumed in a
business combination are recognized by the consolidated entity. This is true regardless of the percentage ownership acquired by the controlling entity. If the
acquirer acquires all of the assets and liabilities of the acquiree in a merger, these assets and liabilities are recorded on the books of the acquiring company at
their acquisition-date fair values. If the acquiring company acquires partial ownership of the acquiree in a stock acquisition, the assets acquired and liabilities
assumed appear at their full acquisition-date fair values in a consolidated balance sheet prepared immediately after the combination.
All costs of bringing about and consummating a business combination are charged to an acquisition expense as incurred. Examples of traceable costs
include finders’ fees, consulting fees, travel costs, and so on. The costs of issuing equity securities used to acquire the acquiree are treated in the same
manner as stock issues costs are normally treated, as a reduction in the paid-in capital associated with the securities.
Goodwill
Conceptually, goodwill as it relates to business combinations consists of all those intangible factors that allow a business to earn above-average profits. From
an accounting perspective, the FASB has stated that goodwill “is an asset representing the future economic benefits arising from other assets acquired in a
business combination that are not individually identified and separately recognized” (ASC 805-10-20). An asset is considered to be identifiable, page 15
and therefore must be separately recognized, if it is separable (can be separated from the business) or arises from a contractual or other right.
FYI
Microsoft recorded roughly $20 billion in goodwill when it acquired LinkedIn in 2016.
Under the acquisition method, an acquirer measures and recognizes goodwill from a business combination based on the difference between the total fair
value of the acquired company and the fair value of its net identifiable assets. However, the FASB decided, for several reasons, not to focus directly on the
total fair value of the acquiree, but rather on the components that provide an indication of that fair value.
The fair value of the consideration given is compared with the acquisition-date fair value of the acquiree’s net identifiable assets, and any excess is
goodwill.
As an example of the computation of goodwill, assume that Pepper Company acquires all of the assets of Salt Company for $400,000 when the fair value
of Salt’s net identifiable assets is $380,000. Goodwill is recognized for the $20,000 difference between the total consideration given and the fair value of the
net identifiable assets acquired. If, instead of an acquisition of assets, Pepper acquires 75 percent of the common stock of Salt for $300,000, and the fair
value of the noncontrolling interest is $100,000, goodwill is computed as follows:
Fair value of consideration given by Pepper
+ Fair value of noncontrolling interest
$300,000
100,000
Total fair value of Salt Company
$400,000
− Fair value of net identifiable assets acquired
(380,000)
Goodwill
$ 20,000
Note that the total amount of goodwill is not affected by whether 100 percent of the acquiree or less than that is acquired. However, the fair value of the
noncontrolling interest does have an effect on the amount of goodwill recognized. In the example given, the fair values of the controlling and noncontrolling
interests are proportional (each is valued at an amount equal to its proportionate ownership share of the total) and imply a total fair value of the acquired
company of $400,000. This is frequently the case and will always be assumed throughout the text unless indicated otherwise. However, that may not always
be the case in practice. Situations might arise in a stock acquisition, for example, where the per-share value of the controlling interest is higher than that of
the noncontrolling interest because of a premium associated with gaining control.
Combination Effected through the Acquisition of Net Assets
When one company acquires all the net assets of another in a business combination, the acquirer records on its books the individual assets acquired and
liabilities assumed in the combination and the consideration given in exchange. Each identifiable asset and liability acquired is recorded by the acquirer at its
acquisition-date fair value. The acquiring company records any excess of the fair value of the consideration exchanged over the fair value of the acquiree’s
net identifiable assets as goodwill.
To illustrate the application of the acquisition method of accounting to a business combination effected through the acquisition of the acquiree’s net
assets, assume that Point Corporation acquires all of the assets and assumes all of the liabilities of Sharp Company in a statutory merger by issuing 10,000
shares of $10 par common stock to Sharp. The shares issued have a total market value of $610,000. Point incurs legal and appraisal fees of
page 16
$40,000 in connection with the combination and stock issue costs of $25,000. Figure 1–2 shows the book values and fair values of Sharp’s
individual assets and liabilities on the date of combination.
FIGURE 1–2
Sharp Company Balance Sheet Information, December 31, 20X0
Assets, Liabilities & Equities
Cash & Receivables
Book Value
Fair Value
$45,000
$ 45,000
Inventory
65,000
75,000
Land
40,000
70,000
400,000
350,000
Buildings & Equipment
Accumulated Depreciation
Patent
(150,000)
80,000
Total Assets
Current Liabilities
Common Stock ($5 par)
Additional Paid-In Capital
Retained Earnings
Total Liabilities & Equities
$400,000
$620,000
$100,000
110,000
100,000
50,000
150,000
$400,000
Fair Value of Net Assets
$510,000
The relationships among the fair value of the consideration exchanged, the fair value of Sharp’s net assets, and the book value of Sharp’s net assets are
illustrated in the following diagram:
The total difference at the acquisition date between the fair value of the consideration exchanged and the book value of the net identifiable assets acquired
is referred to as the differential. In more complex situations, the differential is equal to the difference between (1) the acquisition-date fair value of the
consideration transferred by the acquirer, plus the acquisition-date fair value of any equity interest in the acquiree previously held by the acquirer, plus the fair
value of any noncontrolling interest in the acquiree and (2) the acquisition-date book values of the identifiable assets acquired and liabilities assumed.
In the Point/Sharp merger, the total differential of $310,000 reflects the difference between the total fair value of the shares issued by Point and the
carrying amount of Sharp’s net assets reflected on its books at the date of combination. A portion of that difference ($210,000) is attributable to the
increased value of Sharp’s net assets over book value. The remainder of the difference ($100,000) is considered to be goodwill.
page 17
The $40,000 of acquisition costs incurred by Point in carrying out the acquisition are expensed as incurred:
(3)
Acquisition Expense
40,000
Cash
40,000
Record costs related to acquisition of Sharp Company.
Portions of the $25,000 of stock issue costs related to the shares issued to acquire Sharp may be incurred at various times. To facilitate accumulating
these amounts before recording the combination, Point may record them in a separate temporary “suspense” account as incurred:
(4)
Deferred Stock Issue Costs
25,000
Cash
25,000
Record costs related to issuance of common stock.
On the date of combination, Point records the acquisition of Sharp with the following entry:
(5)
Cash and Receivables
45,000
Inventory
75,000
Land
70,000
Buildings and Equipment
Patent
Goodwill
350,000
80,000
100,000
Current Liabilities
110,000
Common Stock
100,000
Additional Paid-In Capital
485,000
Deferred Stock Issue Costs
25,000
Record acquisition of Sharp Company.
Entry (5) records all of Sharp’s individual assets and liabilities, both tangible and intangible, on Point’s books at their fair values on the date of
combination. The fair value of Sharp’s net assets recorded is $510,000 ($620,000 − $110,000). The $100,000 difference between the fair value of the shares
given by Point ($610,000) and the fair value of Sharp’s net assets is recorded as goodwill.
In recording the business combination, Sharp’s book values are not relevant to Point; only the fair values are recorded. Because a change in ownership
has occurred, the basis of accounting used by the acquired company is not relevant to the acquirer. Consistent with this view, accumulated depreciation
recorded by Sharp on its buildings and equipment is not relevant to Point and is not recorded. (Note that this is different from the way depreciable assets for
an internally created subsidiary were handled previously.)
The stock issue costs are treated as a reduction in the proceeds received from the issuance of the stock. Thus, these costs are removed from the
temporary account with a credit and decrease to Additional Paid-In Capital. Point records the $610,000 of stock issued at its value minus the stock issue
costs, or $585,000. Of this amount, the $100,000 par value is recorded in the Common Stock account and the remainder in Additional Paid-In Capital.
page 18
Entries Recorded by Acquired Company
On the date of the combination, Sharp records the following entry to recognize receipt of the Point shares and the transfer of all individual assets and
liabilities to Point:
(6)
Investment in Point Stock
610,000
Current Liabilities
100,000
Accumulated Depreciation
150,000
Cash and Receivables
45,000
Inventory
65,000
Land
40,000
Buildings and Equipment
400,000
Gain on Sale of Net Assets
310,000
Record transfer of assets to Point Corporation.
Sharp recognizes the fair value of Point Corporation shares at the time of the exchange and records a gain of $310,000. The distribution of Point shares to
Sharp shareholders and the liquidation of Sharp are recorded on Sharp’s books with the following entry:
(7)
Common Stock
Additional Paid-In Capital
100,000
50,000
Retained Earnings
150,000
Gain on Sale of Net Assets
310,000
Investment in Point Stock
610,000
Record distribution of Point Corporation stock.
Subsequent Accounting for Goodwill by Acquirer
The acquirer records goodwill arising in a merger as the difference between the fair value of the consideration exchanged and the fair value of the identifiable
net assets acquired, as illustrated in entry (5). Once the acquirer records goodwill, it must be accounted for in accordance with ASC 350. Goodwill is carried
forward at the originally recorded amount unless it is determined to be impaired. Goodwill must be reported as a separate line item in the balance sheet. A
goodwill impairment loss that occurs subsequent to recording goodwill must be reported as a separate line item within income from continuing operations in
the income statement unless the loss relates to discontinued operations, in which case the loss is reported within the discontinued operations section.
Goodwill must be tested for impairment at least annually, at the same time each year, and more frequently if events that are likely to impair the value of
the goodwill occur. The process of testing goodwill for impairment was recently simplified by the FASB (ASU 2017-04). It requires the testing for goodwill
impairment for each of the company’s reporting units, where a reporting unit is an operating segment9 or a component of an operating segment that is a
business for which management regularly reviews financial information from that component. When goodwill arises in a business combination, it must be
assigned to individual reporting units. The goodwill is assigned to units that are expected to benefit from the combination, even if no other assets or liabilities
of the acquired company are assigned to those units. To test for goodwill impairment, the fair value of the reporting unit is compared with its carrying value.
If the fair value of the reporting unit exceeds its carrying value, the goodwill of that reporting unit is considered unimpaired. On the other hand, if the
carrying value of the reporting unit exceeds its fair value, an impairment of the reporting unit’s goodwill is recorded for the amount by which the carrying
value exceeds the fair value. However, the loss on impairment cannot exceed the value of recorded goodwill for the reporting unit. 10
page 19
As an example of goodwill impairment, assume that Reporting Unit A is assigned $100,000 of goodwill arising from a recent business combination. The
following assets and liabilities are assigned to Reporting Unit A:
Item
Carrying Amount
Cash and Receivables
$ 50,000
Inventory
80,000
Equipment
120,000
Goodwill
100,000
Total Assets
$350,000
Current Payables
Net Assets
(10,000)
$340,000
By summing the carrying amounts of the assets and subtracting the carrying amount of the payables, the net carrying amount of the reporting unit, including
the goodwill, is determined to be $340,000. If the fair value of the reporting unit is estimated to be $360,000 (or any number greater than the carrying
amount), goodwill is not impaired. On the other hand, if the fair value of the reporting unit is estimated to be $280,000, the $60,000 difference ($340,000 −
$280,000) represents Reporting Unit A’s goodwill impairment loss and the goodwill’s new carrying amount is $40,000 (after recording the impairment). Note
that the impairment loss cannot exceed the amount of goodwill assigned to the reporting unit. This goodwill impairment loss is combined with any
impairment losses from other reporting units to determine the total goodwill impairment loss to be reported by the company as a whole. Goodwill is written
down by the amount of the impairment loss. Once written down, goodwill may not be written up for subsequent recoveries.
Bargain Purchase 1 1
Occasionally, the fair value of the consideration given in a business combination, along with the fair value of any equity interest in the acquiree already held
and the fair value of any noncontrolling interest in the acquiree, may be less than the fair value of the acquiree’s net identifiable assets, resulting in a bargain
purchase. This might occur, for example, with a forced sale.
FYI
On September 22, 2008, at the climax of the global financial crisis, Barclays Bank PLC completed the
bargain purchase acquisition of Lehman Brothers’ North American businesses. Lehman Brothers was a former
U.S.-based investment bank. Barclays is an international banking and financial services firm based in
London. Barclays recorded a significant gain on bargain purchase at the time of this acquisition:
In 1000s of USD
$6,098a
Net Assets Acquired
Cash Paid
Attributable Costs
Obligation to Be Settled in Shares
1,541
75
301
Less: Total Consideration
1,917
Gain on Bargain Purchase
$4,181
a Selected Information from Barclays Bank PLC Annual Report 2008 Note 40(a), translated to U.S.$ using the GBPUSD Spot
Rate 9/22/08 of 1.8483£/$.
When a bargain purchase occurs (rarely), the acquirer must take steps to ensure that all acquisition-date valuations are appropriate. If they are, the
acquirer recognizes a gain at the date of acquisition for the excess of the amount of the net identifiable assets acquired and liabilities assumed as valued under
ASC 805, usually at fair value, over the sum of the fair value of the consideration given in the exchange, the fair value of any equity interest in the acquiree
held by the acquirer at the date of acquisition, and the fair value of any noncontrolling interest. Along with the amount of the gain, companies must disclose
the operating segment where the gain is reported and the factors that led to the gain.
To illustrate accounting for a bargain purchase, assume that in the previous example of Point and Sharp, Point is able to acquire Sharp for $500,000 cash
even though the fair value of Sharp’s net identifiable assets is estimated to be $510,000. In this simple bargain-purchase case without an equity
page 20
interest already held or a noncontrolling interest, the fair value of Sharp’s net identifiable assets exceeds the consideration exchanged by Point,
and, accordingly, a $10,000 gain attributable to Point is recognized.
In accounting for the bargain purchase (for cash) on Point’s books, the following entry replaces previous entry (5):
(8)
Cash and Receivables
45,000
Inventory
75,000
Land
70,000
Buildings and Equipment
350,000
Patent
80,000
Cash
500,000
Current Liabilities
110,000
Gain on Bargain Purchase of Sharp Company
10,000
Record acquisition of Sharp Company.
Combination Effected through Acquisition of Stock
Many business combinations are effected by acquiring the voting stock of another company rather than by acquiring its net assets. When a business
combination is effected through a stock acquisition, the acquiree may lose its separate identity and be merged into the acquiring company or it may continue
to operate as a separate company. If the acquired company is liquidated and its assets and liabilities are transferred to the acquirer, the dollar amounts
recorded are identical to those in entry (5).
If the acquired company continues to exist, the acquirer records an investment in the common stock of the acquiree rather than its individual assets and
liabilities. The acquirer records its investment in the acquiree’s common stock at the total fair value of the consideration given in exchange. For example, if
Point Corporation (a) exchanges 10,000 shares of its stock with a total market value of $610,000 for all of Sharp Company’s shares and (b) incurs merger
costs of $40,000 and stock issue costs of $25,000, Point records the following entries upon receipt of the Sharp stock:
(9)
Acquisition Expense
40,000
Deferred Stock Issue Costs
25,000
Cash
65,000
Record merger and stock issue costs related to acquisition of Sharp Company.
(10)
Investment in Sharp Stock
610,000
Common Stock
100,000
Additional Paid-In Capital
485,000
Deferred Stock Issue Costs
25,000
Record acquisition of Sharp Company stock.
The details of the accounting and reporting procedures for intercorporate investments in common stock when the acquiree continues in existence are
discussed in the next nine chapters.
Financial Reporting Subsequent to a Business Combination
Financial statements prepared subsequent to a business combination reflect the combined entity beginning on the date of combination going forward to the
end of the fiscal period. When a combination occurs during a fiscal period, income earned by the acquiree prior to the combination is not reported in the
income of the combined enterprise. If the combined company presents comparative financial statements that include statements for periods before the
combination, those statements include only the activities and financial position of the acquiring company, not those of the combined entity or the acquiree.
page 21
To illustrate financial reporting subsequent to a business combination, assume the following information for Point Corporation and Sharp Company:
20X0
Point Corporation:
20X1
Separate Income (excluding any income from Sharp) $300,000
Shares Outstanding, December 31
$300,000
30,000
40,000
Sharp Company:
Net Income
$60,000
$
60,000
Point Corporation acquires all of Sharp Company’s stock at book value on January 1, 20X1, by issuing 10,000 shares of common stock. Subsequently,
Point Corporation presents comparative financial statements for the years 20X0 and 20X1. The net income and earnings per share (EPS) that Point presents
in its comparative financial statements for the two years are as follows:
20X0:
Net Income
Earnings per Share ($300,000/30,000 shares)
$300,000
$10.00
20X1:
Net Income ($300,000 + $60,000)
Earnings per Share ($360,000/40,000 shares)
$360,000
$9.00
If Point Corporation had acquired Sharp Company in the middle of 20X1 instead of at the beginning, Point would include only Sharp’s earnings
subsequent to acquisition in its 20X1 income statement. If Sharp earned $25,000 in 20X1 before acquisition by Point and $35,000 after the combination,
Point would report total net income for 20X1 of $335,000 ($300,000 + $35,000). Note that if the shares are issued in the middle of the year to effect the
acquisition, the weighted-average shares used in the EPS calculation would change as well.
ADDITIONAL CONSIDERATIONS IN ACCOUNTING FOR BUSINESS COMBINATIONS
L O 1 –6
Understand additional considerations associated with business combinations.
ASC 805 includes a number of requirements relating to specific items or aspects encountered in business combinations. A discussion of the more common
situations follows.
Uncertainty in Business Combinations
Uncertainty affects much of accounting measurement but is especially prevalent in business combinations. Although uncertainty relates to many aspects of
business combinations, three aspects of accounting for business combinations deserve particular attention: the measurement period, contingent consideration,
and acquiree contingencies.
Measurement Period
One type of uncertainty in business combinations arises from numerous required fair value measurements. Because the acquirer may not have sufficient
information available immediately to properly ascertain fair values, ASC 805 allows for a period of time, called the measurement period, to acquire the
necessary information. The measurement period ends once the acquirer obtains the necessary information about the facts as of the acquisition date, but may
not exceed one year beyond the acquisition date.
Assets that have been provisionally recorded as of the acquisition date are retrospectively adjusted in value during the measurement period for new
information that clarifies the acquisition-date value. Usually, the offsetting entry is to goodwill. Retrospective adjustments may not be made for changes in
value that occur subsequent to the acquisition date, even when those changes occur during the measurement period.
page 22
As an illustration, assume that Sonny Company acquires land in a business combination and provisionally records the land at its estimated fair value of
$100,000. During the measurement period, Sonny receives a reliable appraisal that the land was worth $110,000 at the acquisition date. Subsequently, during
the same accounting period, a change in the zoning of a neighboring parcel of land reduces the value of the land acquired by Sonny to $75,000. Sonny
records the clarification of the acquisition-date fair value of the land and the subsequent impairment of value with the following entries:
(11)
Land
10,000
Goodwill
10,000
Adjust acquisition-date value of land acquired in business combination.
(12)
Impairment Loss
Land
Recognize decline in value of land held.
35,000
35,000
Contingent Consideration
Sometimes the consideration exchanged by the acquirer in a business combination is not fixed in amount, but rather is contingent on future events. For
example, the acquiree and acquirer may enter into a contingent-share agreement whereby, in addition to an initial issuance of shares, the acquirer may agree to
issue a certain number of additional shares for each percentage point by which the earnings number exceeds a set amount over the next five years. Thus,
total consideration exchanged in the business combination is not known within the measurement period because the number of shares to be issued is
dependent on future events.
ASC 805 requires contingent consideration in a business combination to be valued at fair value as of the acquisition date (and classified as either a liability
or equity). The right to require the return of consideration given that it is dependent on future events is classified as an asset. Contingent consideration
classified as an asset or liability is remeasured each period to fair value and the change is recognized in income. 12 Contingent consideration classified as
equity is not remeasured.
Acquiree Contingencies
Certain contingencies may relate to an acquiree in a business combination, such as pending lawsuits or loan guarantees made by the acquiree. Certainly, the
acquirer considers such contingencies when entering into an acquisition agreement, and the accounting must also consider such contingencies. Under ASC
805, the acquirer must recognize all contingencies that arise from contractual rights or obligations and other contingencies if it is probable that they meet the
definition of an asset or liability at the acquisition date. The acquirer records these contingencies at acquisition-date fair value.
For all acquired contingencies, the acquirer should provide a description of each, disclose the amount recognized at the acquisition date, and describe the
estimated range of possible undiscounted outcomes. Subsequently, the acquirer should disclose changes in the amounts recognized and in the range of
possible outcomes. Note that the accounting for acquiree contingencies is no different from the accounting for any other contingency.
In-Process Research and Development
In normal operations, research and development costs are required to be expensed as incurred except under certain limited conditions. When a company
acquires valuable ongoing research and development projects from an acquiree in a business combination, a question arises as to whether these page 23
should be recorded as assets. The FASB concluded in ASC 805 that these projects are assets and should be recorded at their acquisition-date fair
values, even if they have no alternative use. These projects should be classified as having indefinite lives and, therefore, should not be amortized until
completed and brought to market. They should be tested for impairment in accordance with current standards. Projects that are subsequently abandoned are
written off when abandoned. Subsequent expenditures for the previously acquired research and development projects would normally be expensed as
incurred.
Noncontrolling Equity Held Prior to Combination
In some cases, an acquirer may hold an equity interest in an acquiree prior to obtaining control through a business combination. The total amount of the
acquirer’s investment in the acquiree subsequent to the combination is equal to the acquisition-date fair value of the equity interest previously held and the fair
value of the consideration given in the business combination. For example, if Potter Company held 10 percent of Snape Company’s stock with a fair value of
$500,000 and Potter acquired the remaining shares of Snape for $4,500,000 cash, Potter’s total investment is considered to be $5,000,000.
An acquirer that held an equity position in an acquiree immediately prior to the acquisition date must revalue that equity position to its fair value at the
acquisition date and recognize a gain or loss on the revaluation. Suppose that Potter’s 10 percent investment in Snape has a book value of $300,000 and fair
value of $500,000 at the date Potter acquires the remaining 90 percent of Snape’s stock. Potter revalues its original investment in Snape to its $500,000 fair
value and recognizes a $200,000 gain on the revaluation at the date it acquires the remaining shares of Snape. Potter records the following entries on its
books in connection with the acquisition of Snape:
(13)
Investment in Snape Company Stock
200,000
Gain on revaluation of Snape Company Stock
200,000
Revalue Snape Company stock to fair value at date of business combination.
(14)
Investment in Snape Company Stock
Cash
4,500,000
4,500,000
Acquire controlling interest in Snape Company.
SUMMARY OF KEY CONCEPTS
Business combinations and complex organizational structures are an important part of the global business scene. Many companies add organizational components
by creating new corporations or partnerships through which to carry out a portion of their operations. In other cases, companies may enter into business
combinations to acquire other companies through which to further their objectives.
When a company creates another corporation or a partnership through a transfer of assets, the book values of those assets are transferred to the new entity and
no gain or loss is recognized. The creating company and the new entity will combine their financial statements for general-purpose financial reporting to appear as if
they were a single company as long as the creating company continues to control the new entity.
A business combination occurs when an acquirer obtains control of one or more other businesses. The three legal forms of business combination that are
commonly found are (a) statutory mergers in which the acquiree loses its separate identity and the acquirer continues with the assets and liabilities of both
companies; (b) statutory consolidations in which both combining companies join to form a new company; and (c) stock acquisitions in which both combining
companies maintain their separate identities, with the acquirer owning the stock of the acquiree.
page 24
ASC 805 requires that the acquisition method be used to account for business combinations. Under the acquisition method, all of the assets acquired and
liabilities assumed by the acquirer in a business combination are valued at their fair values. The excess of the sum of the fair value of the acquirer’s consideration
transferred, the fair value of any equity interest in the acquiree already held, and the fair value of any noncontrolling interest in the acquiree over the fair value of
the net identifiable assets acquired is goodwill. In subsequent financial statements, goodwill must be reported separately. Goodwill of publicly traded companies is
not amortized, but it must be tested for impairment at least annually. If goodwill is impaired, it is written down to its new fair value and a loss is recognized for the
amount of the impairment. If the fair value of the consideration transferred by the acquirer in a business combination, along with the fair value of an equity interest
already held, and the noncontrolling interest is less than the fair value of the acquiree’s net identifiable assets, a situation referred to as a bargain purchase, the
difference is recognized as a gain attributable to the acquirer.
All costs associated with a business combination are expensed as incurred. Any stock issue costs incurred in connection with a business combination are
treated as a reduction in paid-in capital. A business combination is given effect as of the acquisition date for subsequent financial reporting.
KEY TERMS
acquisition method 14
bargain purchase 19
business combination 7
consolidated financial statements 2
control 7
differential 16
goodwill 14
holding company 10
liquidated 10
measurement period 21
minority interest 12
noncontrolling interest 12
parent company 2
parent–subsidiary relationship 10
pooling-of-interests method 8
primary beneficiary 8
special-purpose entity (SPE) 4
spin-off 5
split-off 6
statutory consolidation 10
statutory merger 10
stock acquisition 10
subsidiary 2
tender offer 11
QUESTIONS
Q1–1
What types of circumstances would encourage management to establish a complex
organizational structure?
LO 1–1
Q1–2
How would the decision to dispose of a segment of operations using a split-off rather than a
spin-off impact the financial statements of the company making the distribution?
LO 1–1
Q1–3
Why did companies such as Enron find the use of special-purpose entities to be advantageous?
LO 1–1
Q1–4
Describe each of the three legal forms that a business combination might take.
LO 1–4
Q1–5
When does a noncontrolling interest arise in a business combination?
LO 1–1
Q1–6
How is the amount reported as goodwill determined under the acquisition method?
LO 1–5
Q1–7
What is a differential?
LO 1–5
Q1–8
When a business combination occurs after the beginning of the year, the income earned by the
acquired company between the beginning of the year and the date of combination is excluded
from the net income reported by the combined entity for the year. Why?
LO 1–5
Q1–9
What is the maximum balance in retained earnings that can be reported by the combined entity
immediately following a business combination?
LO 1–5
Q1–10
How is the amount of additional paid-in capital determined when recording a business
combination?
LO 1–5
Q1–11
Which of the costs incurred in completing a business combination are capitalized under the
acquisition method?
LO 1–5
Q1–12
Which of the costs incurred in completing a business combination should be treated as a
reduction of additional paid-in capital?
LO 1–5
Q1–13
When is goodwill considered impaired following a business combination?
LO 1–5
page 25
Q1–14
When does a bargain purchase occur?
LO 1–5
Q1–15
Within the measurement period following a business combination, the acquisition-date fair value
of buildings acquired is determined to be less than initially recorded. How is the reduction in
value recognized?
LO 1–6
Q1–16
P Company reports its 10,000 shares of S Company at $40 per share. P Company then purchases
an additional 60,000 shares of S Company for $65 each and gains control of S Company. What
must be done with respect to the valuation of the shares previously owned?
LO 1–6
CASES
C1–1
Assignment of Acquisition Costs
LO 1–2, 1–5
Research
Troy Company notified Kline Company’s shareholders that it was interested in purchasing controlling ownership of Kline and offered to exchange one share of
Troy’s common stock for each share of Kline Company submitted by July 31, 20X7. At the time of the offer, Troy’s shares were trading for $35 per share and Kline’s
shares were trading at $28. Troy acquired all of the shares of Kline prior to December 31, 20X7, and transferred Kline’s assets and liabilities to its books. In addition
to issuing its shares, Troy paid a finder’s fee of $200,000, stock registration and audit fees of $60,000, legal fees of $90,000 for transferring Kline’s assets and
liabilities to Troy, and $370,000 in legal fees to settle litigation brought by Kline’s shareholders who alleged that the offering price was below the per-share fair value
of Kline’s net assets.
Required
Troy Company’s vice president of finance has asked you to review the current accounting literature, including authoritative pronouncements, and prepare a memo
reporting the required treatment of the additional costs at the time Kline Company was acquired. Support your recommendations with citations and quotations from
the authoritative financial reporting standards or other literature.
C1–2
Evaluation of Merger
LO 1–1, 1–3
Research
One company may acquire another for a number of different reasons. The acquisition often has a significant impact on the financial statements. In 2017, AT&T
Corporation acquired Time Warner. Obtain a copy of the AT&T 10-K filing for 2017. The 10-K reports the annual results for a company and is often available on the
Investor Relations section of a company’s website. It is also available on the SEC’s website at www.sec.gov.
Required
Use the 10-K for 2017 to find the answers to the following questions about AT&T’s acquisition of Time Warner. (Hint: You can search for the term Time Warner once
you have accessed the 10-K online.)
a.
Provide at least one reason that AT&T acquired Time Warner. How did this acquisition benefit AT&T strategically?
b.
What consideration did AT&T give to Time Warner shareholders?
c.
How was the acquisition funded?
d.
What type of acquisition discussed in this chapter describes this merger? Why would this type of merger be appropriate given the consideration given?
C1–3
Business Combinations
LO 1–4
Analysis
A merger boom comparable to those of the 1960s and mid-1980s occurred in the 1990s and into the new century. The merger activity of the 1960s was associated
with increasing stock prices and heavy use of pooling-of-interests accounting. The mid-1980s activity was associated with a number of leveraged buyouts and
acquisitions involving junk bonds. Merger activity in the early 1990s, on the other hand, appeared to involve primarily purchases with cash and standard debt
instruments. By the mid-1990s, however, many business combinations were being effected through exchanges of stock. In the first decade of the new century, the
nature of many business acquisitions changed, and by late 2008, the merger boom had slowed dramatically.
a.
Why were so many of the business combinations in the middle and late 1990s effected through exchanges of stock?
b.
What factors had a heavy influence on mergers during the mid-2000s? How did many of the business combinations of this period differ from earlier page 26
combinations? Why did the merger boom slow so dramatically late in 2008 and in 2009? What is the new focus since that time?
c.
If a major review of the tax laws were undertaken, would it be wise or unwise public policy to establish greater tax incentives for corporate mergers? Propose three
incentives that might be used.
d.
If the FASB were interested in encouraging more mergers, what action should it take with regard to revising or eliminating existing accounting standards? Explain.
C1–4
Determination of Goodwill Impairment
LO 1–5
Research
Plush Corporation purchased 100 percent of Common Corporation’s common stock on January 1, 20X3, and paid $450,000. The fair value of Common’s identifiable
net assets at that date was $430,000. By the end of 20X5, the fair value of Common, which Plush considers to be a reporting unit, had increased to $485,000;
however, Plush’s external auditor made a passing comment to the company’s chief accountant that Plush might need to recognize impairment of goodwill on one or
more of its investments.
Required
Prepare a memo to Plush’s chief accountant indicating the tests used in determining whether goodwill has been impaired. Include in your discussion one or more
possible conditions under which Plush might be required to recognize impairment of goodwill on its investment in Common Corporation. In preparing your memo,
review the current accounting literature, including authoritative pronouncements of the FASB and other appropriate bodies. Support your discussion with citations
and quotations from the applicable literature.
C1–5
Risks Associated with Acquisitions
LO 1–1
Analysis
Not all business combinations are successful, and many entail substantial risk. Acquiring another company may involve a number of different types of risk. Obtain a
copy of the 10-K report for Alphabet Inc. (parent company of Google Inc.) for the year ended December 31, 2016, available at the SEC’s website (www.sec.gov). The
report also can be accessed through Yahoo! Finance or the company’s Investor Relations page.
Required
On pages 9-10 of the 10-K report, Alphabet provides information to investors about its motivation for acquiring companies and the possible risks associated with
such acquisitions. Briefly discuss the risks that Google sees inherent in potential acquisitions
C1–6
Leveraged Buyouts
LO 1–4
Analysis
A type of acquisition that was not discussed in the chapter is the leveraged buyout. Many experts argue that a leveraged buyout (LBO) is not a type of business
combination but rather just a restructuring of ownership. Yet some would see an LBO as having many of the characteristics of a business combination. The number
of LBOs in recent years has grown dramatically and, therefore, accounting for these transactions is of increased importance.
Required
a.
What is a leveraged buyout? How does an LBO compare with a management buyout (MBO)?
b.
What authoritative pronouncements, if any, deal with leveraged buyouts?
c.
Is a leveraged buyout a type of business combination? Explain.
d.
What is the major issue in determining the proper basis for an interest in a company purchased through a leveraged buyout?
EXERCISES
E1–1
Multiple-Choice Questions on Complex Organizations
LO 1–1, 1–3, 1–5
Select the correct answer for each of the following questions.
1. Growth in the complexity of the U.S. business environment
a. Has led to increased use of partnerships to avoid legal liability.
b. Has led to increasingly complex organizational structures as management has attempted to achieve its business objectives.
c. Has encouraged companies to reduce the number of operating divisions and product lines so they may better control those they retain.
d. Has had no particular impact on the organizational structures or the way in which companies are managed.
2. Which of the following is not an appropriate reason for establishing a subsidiary?
page 27
a. The parent wishes to protect existing operations by shifting new activities with greater risk to a newly created subsidiary.
b. The parent wishes to avoid subjecting all of its operations to regulatory control by establishing a subsidiary that focuses its operations in regulated
industries.
c. The parent wishes to reduce its taxes by establishing a subsidiary that focuses its operations in areas where special tax benefits are available.
d. The parent wishes to be able to increase its reported sales by transferring products to the subsidiary at the end of the fiscal year.
3. Which of the following actions is likely to result in recording goodwill on Poker Company’s books?
a. Poker acquires Spade Corporation in a business combination recorded as a merger.
b. Poker acquires a majority of Spade’s common stock in a business combination and continues to operate it as a subsidiary.
c. Poker distributes ownership of a newly created subsidiary in a distribution considered to be a spin-off.
d. Poker distributes ownership of a newly created subsidiary in a distribution considered to be a split-off.
4. When an existing company creates a new subsidiary and transfers a portion of its assets and liabilities to the new entity
a. The new entity records both the assets and liabilities it received at fair values.
b. The new entity records both the assets and liabilities it received at the carrying values of the original company.
c. The original company records a gain or loss on the difference between its carrying values and the fair values of the assets transferred to the new entity.
d. The original company records the difference between the carrying values and the fair values of the assets transferred to the new entity as goodwill.
5. When a company assigns goodwill to a reporting unit acquired in a business combination, it must record an impairment loss if
a. The fair value of the net identifiable assets held by a reporting unit decreases.
b. The fair value of the reporting unit decreases.
c. The carrying value of the reporting unit is less than the fair value of the reporting unit.
d. The fair value of the reporting unit is less than its carrying value.
E1–2
Multiple-Choice Questions on Recording Business Combinations [AICPA
Adapted]
LO 1–2, 1–5
Select the correct answer for each of the following questions.
1. Goodwill represents the excess of the sum of the fair value of the (1) consideration given, (2) shares already owned, and (3) the noncontrolling interest over the
a. Sum of the fair values assigned to identifiable assets acquired less liabilities assumed.
b. Sum of the fair values assigned to tangible assets acquired less liabilities assumed.
c. Sum of the fair values assigned to intangible assets acquired less liabilities assumed.
d. Book value of an acquired company.
2. In a business combination, costs of registering equity securities to be issued by the acquiring company are a(n)
a. Expense of the combined company for the period in which the costs were incurred.
b. Direct addition to stockholders’ equity of the combined company.
c. Reduction of the recorded value of the securities.
d. Addition to goodwill.
3. Which of the following is the appropriate basis for valuing fixed assets acquired in a business combination carried out by exchanging cash for page 28
common stock?
a. Historical cost.
b. Book value.
c. Cost plus any excess of purchase price over book value of assets acquired.
d. Fair value.
4. In a business combination in which an acquiring company purchases 100 percent of the outstanding common stock of another company, if the fair value of the
net identifiable assets acquired exceeds the fair value of the consideration given. The excess should be reported as a
a. Deferred credit.
b. Reduction of the values assigned to current assets and a deferred credit for any unallocated portion.
c. Pro rata reduction of the values assigned to current and noncurrent assets and a deferred credit for any unallocated portion.
d. No answer listed is correct.
5. A and B Companies have been operating separately for five years. Each company has a minimal amount of liabilities and a simple capital structure consisting
solely of voting common stock. In exchange for 40 percent of its voting stock, A Company acquires 80 percent of the common stock of B Company. This is a
“tax-free” stock-for-stock exchange for tax purposes. B Company’s identifiable assets have a total net fair market value of $800,000 and a total net book value of
$580,000. The fair market value of the A stock used in the exchange is $700,000, and the fair value of the noncontrolling interest is $175,000. The goodwill
resulting from this acquisition would be
a. Zero.
b. $60,000.
c. $75,000.
d. $295,000.
E1–3
Multiple-Choice Questions on Reported Balances [AICPA Adapted]
LO 1–2, 1–5
Select the correct answer for each of the following questions.
1. On December 31, 20X3, Saxe Corporation was merged into Poe Corporation. In the business combination, Poe issued 200,000 shares of its $10 par common
stock, with a market price of $18 a share, for all of Saxe’s common stock. The stockholders’ equity section of each company’s balance sheet immediately before
the combination was:
Poe
Saxe
$3,000,000
$1,500,000
Additional Paid-In Capital
1,300,000
150,000
Retained Earnings
2,500,000
850,000
$6,800,000
$2,500,000
Common Stock
In the December 31, 20X3, combined balance sheet, additional paid-in capital should be reported at
a. $950,000.
b. $1,300,000.
c. $1,450,000.
d. $2,900,000.
2. On January 1, 20X1, Portland Corporation issued 10,000 shares of common stock in exchange for all of Stockton Corporation’s outstanding stock. Condensed
balance sheets of Portland and Stockton immediately before the combination follow:
page 29
Portland
Stockton
Total Assets
$1,000,000
$500,000
Liabilities
$ 300,000
$150,000
Common Stock ($10 par)
200,000
100,000
Retained Earnings
500,000
250,000
$1,000,000
$500,000
Total Liabilities & Equities
Portland’s common stock had a market price of $60 per share on January 1, 20X1. The market price of Stockton’s stock was not readily determinable. The fair
value of Stockton’s net identifiable assets was determined to be $570,000. Portland’s investment in Stockton’s stock will be stated in Portland’s balance sheet
immediately after the combination in the amount of
a. $350,000.
b. $500,000.
c. $570,000.
d. $600,000.
3. On April 1, 20X2, Pack Company paid $800,000 for all of Sack Corporation’s issued and outstanding common stock. Sack’s recorded assets and liabilities on
April 1, 20X2, were as follows:
Cash
$
Inventory
80,000
240,000
Property & Equipment (net of accumulated depreciation of $320,000)
Liabilities
480,000
(180,000)
On April 1, 20X2, Sack’s inventory was determined to have a fair value of $190,000, and the property and equipment had a fair value of $560,000. What is the
amount of goodwill resulting from the business combination?
a. $0
b. $50,000
c. $150,000
d. $180,000
4. Pickle Corporation issued nonvoting preferred stock with a fair market value of $4,000,000 in exchange for all the outstanding common stock of Sickle
Corporation. On the date of the exchange, Sickle had tangible net assets with a book value of $2,000,000 and a fair value of $2,500,000. In addition, Pickle issued
preferred stock valued at $400,000 to an individual as a finder’s fee in arranging the transaction. As a result of this transaction, Pickle should record an increase
in net assets of
a. $2,000,000.
b. $2,500,000.
c. $4,000,000.
d. $4,400,000.
E1–4
Multiple-Choice Questions Involving Account Balances
LO 1–2, 1–5
Select the correct answer for each of the following questions.
1. Popper Company established a subsidiary and transferred equipment with a fair value of $72,000 to the subsidiary. Popper had purchased the equipment with a
10-year expected life 4 years earlier for $100,000 and has used straight-line depreciation with no expected residual value. At the time of the transfer, the
subsidiary should record
a. Equipment at $72,000 and no accumulated depreciation.
b. Equipment at $60,000 and no accumulated depreciation.
c. Equipment at $100,000 and accumulated depreciation of $40,000.
d. Equipment at $120,000 and accumulated depreciation of $48,000.
2. Pead Corporation established a new subsidiary and transferred to it assets with a cost of $90,000 and a book value of $75,000. The assets had a fair page 30
value of $100,000 at the time of transfer. The transfer will result in
a. A reduction of net assets reported by Pead Corporation of $90,000.
b. A reduction of net assets reported by Pead Corporation of $75,000.
c. No change in the reported net assets of Pead Corporation.
d. An increase in the net assets reported by Pead Corporation of $25,000.
3. Salt Company, a newly established subsidiary of Pepper Corporation, received assets with an original cost of $260,000, a fair value of $200,000, and a book
value of $140,000 from the parent in exchange for 7,000 shares of Salt’s $8 par value common stock. Salt should record
a. Additional paid-in capital of $0.
b. Additional paid-in capital of $84,000.
c. Additional paid-in capital of $144,000.
d. Additional paid-in capital of $204,000.
4. Pout Company reports assets with a carrying value of $420,000 (including goodwill with a carrying value of $35,000) assigned to an identifiable reporting unit
purchased at the end of the prior year. The fair value of the reporting unit is currently $350,000, and the carrying value of the net assets held by the reporting
unit is $330,000. At the end of the current period, Pout should report goodwill of
a. $45,000.
b. $35,000.
c. $25,000.
d. $10,000.
5. Pill Company has a reporting unit and the fair value of its net identifiable assets of $500,000. The carrying value of the reporting unit’s net assets on Pill’s books
is $575,000, which includes $90,000 of goodwill. The estimated fair value of the reporting unit is $560,000. Pill should report impairment of goodwill of
a. $60,000.
b. $30,000.
c. $15,000.
d. $0.
E1–5
Asset Transfer to Subsidiary
LO 1–3
Pale Company was established on January 1, 20X1. Along with other assets, it immediately purchased land for $80,000, a building for $240,000, and equipment for
$90,000. On January 1, 20X5, Pale transferred these assets, cash of $21,000, and inventory costing $37,000 to a newly created subsidiary, Sight Company, in
exchange for 10,000 shares of Sight’s $6 par value stock. Pale uses straight-line depreciation and useful lives of 40 years and 10 years for the building and
equipment, respectively, with no estimated residual values.
Required
a.
Give the journal entry that Pale recorded when it transferred the assets to Sight.
b.
Give the journal entry that Sight recorded for the receipt of assets and issuance of common stock to Pale.
E1–6
Creation of New Subsidiary
LO 1–3
Pester Company transferred the following assets to a newly created subsidiary, Shumby Corporation, in exchange for 40,000 shares of its $3 par value stock:
Cost
Book Value
$ 40,000
$ 40,000
Accounts Receivable
75,000
68,000
Inventory
50,000
50,000
Land
35,000
35,000
Buildings
160,000
125,000
Equipment
240,000
180,000
Cash
page 31
Required
a.
Give the journal entry in which Pester recorded the transfer of assets to Shumby Corporation.
b.
Give the journal entry in which Shumby recorded the receipt of assets and issuance of common stock to Pester.
E1–7
Balance Sheet Totals of Parent Company
LO 1–2, 1–3
Phoster Corporation established Skine Company as a wholly owned subsidiary. Phoster reported the following balance sheet amounts immediately before and after
it transferred assets and accounts payable to Skine Company in exchange for 4,000 shares of $12 par value common stock:
Required
a.
Give the journal entry that Phoster recorded when it transferred its assets and accounts payable to Skine.
b.
Give the journal entry that Skine recorded upon receipt of the assets and accounts payable from Phoster.
E1–8
Acquisition of Net Assets
LO 1–2, 1–5
Pun Corporation concluded the fair value of Slender Company was $60,000 and paid that amount to acquire its net assets. Slender reported assets with a book value
of $55,000 and fair value of $71,000 and liabilities with a book value and fair value of $20,000 on the date of combination. Pun also paid $4,000 to a search firm for
finder’s fees related to the acquisition.
Required
Give the journal entries to be made by Pun to record its investment in Slender and its payment of the finder’s fees.
E1–9
Reporting Goodwill
LO 1–5
Samper Company reported the book value of its net assets at $160,000 when Public Corporation acquired 100 percent of its voting stock for cash. The fair value of
Samper’s net assets was determined to be $190,000 on that date.
Required
Determine the amount of goodwill to be reported in consolidated financial statements presented immediately following the combination and the amount at which
Public will record its investment in Samper if the amount paid by Public is
a.
$310,000.
b.
$196,000.
c.
$150,000.
E1–10
Stock Acquisition
LO 1–5
Permott Corporation has been in the midst of a major expansion program. Much of its growth had been internal, but in 20X1 Permott decided to continue its
expansion through the acquisition of other companies. The first company acquired was Sippy Inc., a small manufacturer of inertial guidance systems for page 32
aircraft and missiles. On June 10, 20X1, Permott issued 17,000 shares of its $25 par common stock for all 40,000 of Sippy’s $10 par common shares. At the
date of combination, Sippy reported additional paid-in capital of $100,000 and retained earnings of $350,000. Permott’s stock was selling for $58 per share
immediately prior to the combination. Subsequent to the combination, Sippy operated as a subsidiary of Permott.
Required
Present the journal entry or entries that Permott would make to record the business combination with Sippy.
E1–11
Balances Reported Following Combination
LO 1–5
Palm Corporation and Staple Company have announced terms of an exchange agreement under which Palm will issue 8,000 shares of its $10 par value common stock
to acquire all of Staple Company’s assets. Palm shares currently are trading at $50, and Staple $5 par value shares are trading at $18 each. Historical cost and fair
value balance sheet data on January 1, 20X2, are as follows:
Required
What amount will be reported immediately following the business combination for each of the following items in the combined company’s balance sheet?
a.
Common Stock.
b.
Cash and Receivables.
c.
Land.
d.
Buildings and Equipment (net).
e.
Goodwill.
f.
Additional Paid-In Capital.
g.
Retained Earnings.
E1–12
Goodwill Recognition
LO 1–5
Spur Corporation reported the following balance sheet amounts on December 31, 20X1:
Balance Sheet Item
Cash & Receivables
Inventory
Land
Plant & Equipment
Less: Accumulated Depreciation
Historical Cost
Fair Value
$ 50,000
$ 40,000
100,000
150,000
40,000
30,000
400,000
350,000
(150,000)
Patent
130,000
Total Assets
$440,000
$700,000
Accounts Payable
$ 80,000
$ 85,000
Common Stock
Additional Paid-In Capital
200,000
20,000
Retained Earnings
140,000
Total Liabilities & Equities
$440,000
page 33
Required
Planket acquired Spur Corporation’s assets and liabilities for $670,000 cash on December 31, 20X1. Give the entry that Planket made to record the purchase.
E1–13
Acquisition Using Debentures
LO 1–5
Planter Corporation used debentures with a par value of $625,000 to acquire 100 percent of Sorden Company’s net assets on January 1, 20X2. On that date, the fair
value of the bonds issued by Planter was $608,000. The following balance sheet data were reported by Sorden:
Balance Sheet Item
Historical Cost
Fair Value
$ 55,000
$ 50,000
105,000
200,000
60,000
100,000
400,000
300,000
Cash & Receivables
Inventory
Land
Plant & Equipment
Less: Accumulated Depreciation
Goodwill
(150,000)
10,000
Total Assets
$480,000
$650,000
Accounts Payable
$ 50,000
$ 50,000
Common Stock
100,000
Additional Paid-In Capital
60,000
Retained Earnings
270,000
Total Liabilities & Equities
$480,000
Required
Give the journal entry that Planter recorded at the time of exchange.
E1–14
Bargain Purchase
LO 1–5
Using the data presented in E1-13, determine the amount Planter Corporation would record as a gain on bargain purchase and prepare the journal entry Planter
would record at the time of the exchange if Planter issued bonds with a par value of $580,000 and a fair value of $564,000 in completing the acquisition of Sorden.
E1–15
Goodwill Impairment
LO 1–5
On January 1, 20X1, Porta Corporation purchased Swick Company’s net assets and assigned goodwill of $80,000 to Reporting Division K. The following assets and
liabilities are assigned to Reporting Division K on the acquisition date:
Carrying Amount
Fair Value
$ 14,000
$ 14,000
Inventory
56,000
71,000
Equipment
170,000
190,000
Goodwill
80,000
Accounts Payable
30,000
Cash
30,000
Required
On December 31, 20X3, Porta must test goodwill for impairment. Determine the amount of goodwill to be reported for Division K and the amount of goodwill
impairment to be recognized, if any, if Division K’s fair value is determined to be
a.
$340,000.
b.
$280,000.
c.
$260,000.
page 34
E1–16
Goodwill Impairment
LO 1–5
Practical Corporation acquired all of the common stock of Simple Company for $450,000 on January 1, 20X4. On that date, Simple’s identifiable net assets had a fair
value of $390,000. The assets acquired in the purchase of Simple are considered to be a separate reporting unit of Practical. The carrying value of the Simple
reporting unit’s net assets at December 31, 20X4, is $500,000.
Required
Determine the amount of goodwill impairment, if any, that should be recognized at December 31, 20X4, if the fair value of the Simple reporting unit is determined to
be
a.
$530,000.
b.
$485,000.
c.
$450,000.
E1–17
Goodwill Assigned to Reporting Units
LO 1–5
On January 1, 20X7, Proft Company purchased Strobe Company’s net assets and assigned them to four separate reporting units. Total goodwill of $176,000 is
assigned to the reporting units as indicated:
Required
Determine the amount of goodwill that Proft should report at December 31, 20X7. Show how you computed it.
E1–18
Goodwill Measurement
LO 1–5
Plasher Company has a reporting unit resulting from an earlier business combination. The reporting unit’s current assets and liabilities are
Carrying Amount
Fair Value
$ 30,000
$ 30,000
Inventory
70,000
100,000
Land
30,000
60,000
210,000
230,000
Cash
Buildings
Equipment
160,000
Goodwill
150,000
Notes Payable
100,000
170,000
100,000
Required
Determine the amount of goodwill to be reported and the amount of goodwill impairment, if any, if the total fair value of the reporting unit is estimated to be
a.
$580,000.
b.
$540,000.
c.
$500,000.
d.
$460,000.
E1–19
Computation of Fair Value
LO 1–5
Prant Company acquired all of Sedford Corporation’s assets and liabilities on January 1, 20X2, in a business combination. At that date, Sedford reported assets with
a book value of $624,000 and liabilities of $356,000. Prant noted that Sedford had $40,000 of capitalized research and development costs on its books at the page 35
acquisition date that did not appear to be of value. Prant also determined that patents developed by Sedford had a fair value of $120,000 but had not been
recorded by Sedford. Except for buildings and equipment, Prant determined the fair value of all other assets and liabilities reported by Sedford approximated the
recorded amounts. In recording the transfer of assets and liabilities to its books, Prant recorded goodwill of $93,000. Prant paid $517,000 to acquire Sedford’s assets
and liabilities. If the book value of Sedford’s buildings and equipment was $341,000 at the date of acquisition, what was their fair value?
E1–20
Computation of Shares Issued and Goodwill
LO 1–5
Punyain Company acquired Sallsap Corporation on January 1, 20X1, through an exchange of common shares. All of Sallsap’s assets and liabilities were immediately
transferred to Punyain, which reported total par value of shares outstanding of $218,400 and $327,600 and additional paid-in capital of $370,000 and $650,800
immediately before and after the business combination, respectively.
Required
a.
Assuming that Punyain’s common stock had a market value of $25 per share at the time of exchange, what number of shares was issued?
b.
What is the par value per share of Punyain’s common stock?
c.
Assuming that Sallsap’s identifiable assets had a fair value of $476,000 and its liabilities had a fair value of $120,000, what amount of goodwill did Punyain record
at the time of the business combination?
E1–21
Combined Balance Sheet
LO 1–5
The following balance sheets were prepared for Pam Corporation and Slest Company on January 1, 20X2, just before they entered into a business combination:
Pam acquired all of Slest Company’s assets and liabilities on January 1, 20X2, in exchange for its common shares. Pam issued 8,000 shares of stock to complete the
business combination.
Required
Prepare a balance sheet of the combined company immediately following the acquisition, assuming Pam’s shares were trading at $60 each.
E1–22
Recording a Business Combination
LO 1–5
The following financial statement information was prepared for Plue Corporation and Sparse Company at December 31, 20X2:
page 36
Plue and Sparse agreed to combine as of January 1, 20X3. To effect the merger, Plue paid finder’s fees of $30,000 and legal fees of $24,000. Plue also paid $15,000 of
audit fees related to the issuance of stock, stock registration fees of $8,000, and stock listing application fees of $6,000.
At January 1, 20X3, book values of Sparse Company’s assets and liabilities approximated market value except for inventory with a market value of $200,000,
buildings and equipment with a market value of $350,000, and bonds payable with a market value of $105,000. All assets and liabilities were immediately recorded on
Plue’s books.
Required
Give all journal entries that Plue recorded assuming Plue issued 40,000 shares of $8 par value common stock to acquire all of Sparse’s assets and liabilities in a
business combination. Plue common stock was trading at $14 per share on January 1, 20X3.
E1–23
Reporting Income
LO 1–5
On July 1, 20X2, Alan Enterprises merged with Terry Corporation through an exchange of stock and the subsequent liquidation of Terry. Alan issued 200,000 shares
of its stock to effect the combination. The book values of Terry’s assets and liabilities were equal to their fair values at the date of combination, and the value of the
shares exchanged was equal to Terry’s book value. Information relating to income for the companies is as follows:
20X1
Jan. 1–June 30, 20X2
July 1–Dec. 31, 20X2
Alan Enterprises
$4,460,000
$2,500,000
$3,528,000
Terry Corporation
1,300,000
692,000
Net Income:
—
Alan Enterprises had 1,000,000 shares of stock outstanding prior to the combination. Remember that when calculating earnings per share (EPS) for the year of the
combination, the shares issued in the combination were not outstanding for the entire year.
Required
Compute the net income and earnings-per-share amounts that would be reported in Alan’s 20X2 comparative income statements for both 20X2 and 20X1.
page 37
PROBLEMS
P1–24
Assets and Accounts Payable Transferred to Subsidiary
LO 1–3
Pab Corporation decided to establish Sollon Company as a wholly owned subsidiary by transferring some of its existing assets and liabilities to the new entity. In
exchange, Sollon issued Pab 30,000 shares of $6 par value common stock. The following information is provided on the assets and accounts payable transferred:
Cost
Book Value
Fair Value
$ 25,000
$ 25,000
$ 25,000
Inventory
70,000
70,000
70,000
Land
60,000
60,000
90,000
Buildings
170,000
130,000
240,000
Equipment
90,000
80,000
105,000
Accounts Payable
45,000
45,000
45,000
Cash
Required
a.
Give the journal entry that Pab recorded for the transfer of assets and accounts payable to Sollon.
b.
Give the journal entry that Sollon recorded for the receipt of assets and accounts payable from Pab.
P1–25
Creation of New Subsidiary
LO 1–3
Pagle Corporation established a subsidiary to enter into a new line of business considered to be substantially more risky than Pagle’s current business. Pagle
transferred the following assets and accounts payable to Sand Corporation in exchange for 5,000 shares of $10 par value stock of Sand:
Cost
Book Value
$ 30,000
$ 30,000
Accounts Receivable
45,000
40,000
Inventory
60,000
60,000
Land
20,000
20,000
300,000
260,000
10,000
10,000
Cash
Buildings & Equipment
Accounts Payable
Required
a.
Give the journal entry that Pagle recorded for the transfer of assets and accounts payable to Sand.
b.
Give the journal entry that Sand recorded for receipt of the assets and accounts payable from Pagle.
P1–26
Incomplete Data on Creation of Subsidiary
LO 1–3
Plumb Company created Stew Company as a wholly owned subsidiary by transferring assets and accounts payable to Stew in exchange for its common stock. Stew
recorded the following entry when it received the assets and accounts payable:
Cash
3,000
Accounts Receivable
16,000
Inventory
27,000
Land
9,000
Buildings
70,000
Equipment
60,000
Accounts Payable
14,000
Accumulated Depreciation—Buildings
21,000
Accumulated Depreciation—Equipment
12,000
Common Stock
40,000
Additional Paid-In Capital
98,000
page 38
Required
a.
What was Plumb’s book value of the total assets (not net assets) transferred to Stew Company?
b.
What amount did Plumb report as its investment in Stew after the transfer?
c.
What number of shares of $5 par value stock did Stew issue to Plumb?
d.
What impact did the transfer of assets and accounts payable have on the amount reported by Plumb as total assets?
e.
What impact did the transfer of assets and accounts payable have on the amount that Plumb and the consolidated entity reported as shares outstanding?
P1–27
Acquisition in Multiple Steps
LO 1–5
Peal Corporation issued 4,000 shares of its $10 par value stock with a market value of $85,000 to acquire 85 percent of the common stock of Seed Company on
August 31, 20X3. Seed’s fair value was determined to be $100,000 on that date. Peal had earlier purchased 15 percent of Seed’s common stock for $9,000 on January
31, 20X1, and had carried this investment at fair value on its balance. Peal reported this investment at $15,000 on its balance sheet at August 31, 20X3, immediately
prior to acquiring the remaining 85 percent of Seed’s shares. On August 31, 20X3, Peal also paid appraisal fees of $3,500 and stock issue costs of $2,000 incurred in
completing the acquisition of the additional shares.
Required
Give the journal entries to be recorded by Peal in completing the acquisition of the additional shares of Seed.
P1–28
Journal Entries to Record a Business Combination
LO 1–5
On January 1, 20X2, Prost Company acquired all of SKK Corporation’s assets and liabilities by issuing 24,000 shares of its $4 par value common stock. At that date,
Prost shares were selling at $22 per share. Historical cost and fair value balance sheet data for SKK at the time of acquisition were as follows:
Balance Sheet Item
Historical Cost
Fair Value
$ 28,000
$ 28,000
94,000
122,000
600,000
470,000
Cash & Receivables
Inventory
Buildings & Equipment
Less: Accumulated Depreciation
(240,000)
Total Assets
$482,000
$620,000
Accounts Payable
$ 41,000
$ 41,000
65,000
63,000
Notes Payable
Common Stock ($10 par value)
160,000
Retained Earnings
216,000
Total Liabilities & Equities
$482,000
Prost paid legal fees for the transfer of assets and liabilities of $14,000. Prost also paid audit fees of $21,000 and listing application fees of $7,000, both related to the
issuance of new shares.
Required
Prepare the journal entries made by Prost to record the business combination.
P1–29
Recording Business Combinations
LO 1–5
Plint Corporation exchanged shares of its $2 par common stock for all of Sark Company’s assets and liabilities in a planned merger. Immediately prior to the
combination, Sark’s assets and liabilities were as follows:
page 39
Assets
Cash & Equivalents
Accounts Receivable
$
41,000
73,000
Inventory
144,000
Land
200,000
Buildings
1,520,000
Equipment
638,000
Accumulated Depreciation
Total Assets
(431,000)
$2,185,000
Liabilities & Equities
Accounts Payable
Short-Term Notes Payable
$
35,000
50,000
Bonds Payable
500,000
Common Stock ($10 par)
1,000,000
Additional Paid-In Capital
325,000
Retained Earnings
275,000
Total Liabilities & Equities
$2,185,000
Immediately prior to the combination, Plint reported $250,000 additional paid-in capital and $1,350,000 retained earnings. The fair values of Sark’s assets and
liabilities were equal to their book values on the date of combination except that Sark’s buildings were worth $1,500,000 and its equipment was worth $300,000. Costs
associated with planning and completing the business combination totaled $38,000, and stock issue costs totaled $22,000. The market value of Plint’s stock at the
date of combination was $4 per share.
Required
Prepare the journal entries that would appear on Plint’s books to record the combination if Plint issued 450,000 shares.
P1–30
Business Combination with Goodwill
LO 1–5
Pancor Corporation paid cash of $178,000 to acquire Sink Company’s net assets on February 1, 20X3. The balance sheet data for the two companies and fair value
information for Sink immediately before the business combination were
Required
a.
Give the journal entry recorded by Pancor Corporation when it acquired Sink’s net assets.
b.
Prepare a balance sheet for Pancor immediately following the acquisition.
c.
Give the journal entry to be recorded by Pancor if it acquires all of Sink’s common stock (instead of Sink’s net assets) for $178,000.
page 40
P1–31
Bargain Purchase
LO 1–5
Power Company purchased Sark Corporation’s net assets on January 3, 20X2, for $625,000 cash. In addition, Power incurred $5,000 of direct costs in consummating
the combination. At the time of acquisition, Sark reported the following historical cost and current market data:
Balance Sheet Item
Book Value
Fair Value
$ 50,000
$ 50,000
Inventory
100,000
150,000
Buildings & Equipment (net)
200,000
300,000
—
200,000
Total Assets
$350,000
$700,000
Accounts Payable
$ 30,000
$ 30,000
Cash & Receivables
Patent
Common Stock
100,000
Additional Paid-In Capital
Retained Earnings
Total Liabilities & Equities
80,000
140,000
$350,000
Required
Give the journal entry or entries with which Power recorded its acquisition of Sark’s net assets.
P1–32
Computation of Account Balances
LO 1–5
Saspro Division is considered to be an individual reporting unit of Pabor Company. Pabor acquired the division by issuing 100,000 shares of its common stock with
a market price of $7.60 each. Pabor’s management was able to identify assets with fair values of $810,000 and liabilities of $190,000 at the acquisition date. At the end
of the first year, the fair value of the reporting entity was estimated to be $930,000. On this date, Pabor’s accountants concluded that it must recognize a goodwill
impairment of $30,000.
Required
a.
Determine the initial amount of goodwill recorded on the acquisition date. Show your computation.
b.
If the carrying value of the reporting unit’s liabilities at the end of the period were $70,000, what is the maximum carrying value of the reporting unit’s assets that
would allow Pabor to avoid recognizing a goodwill impairment? Show your computation.
P1–33
Goodwill Assigned to Multiple Reporting Units
LO 1–5
The fair values of assets and liabilities held by three reporting units and other information related to the reporting units owned by Prover Company are as follows:
Reporting Unit
A
Cash & Receivables
$
B
30,000
$
C
80,000
$
20,000
Inventory
60,000
100,000
40,000
Land
20,000
30,000
10,000
100,000
150,000
80,000
Buildings
Equipment
140,000
90,000
50,000
40,000
60,000
10,000
Fair Value of Reporting Unit
400,000
440,000
265,000
Carrying Value of Investment
420,000
500,000
290,000
70,000
50,000
40,000
Accounts Payable
Goodwill Included in Carrying Value
Required
a.
Determine the amount, if any, that Prover should report as a goodwill impairment for the current period.
b.
Determine the amount of goodwill that Prover should report in its current financial statements.
page 41
P1–34
Journal Entries
LO 1–5
On January 1, 20X3, Pure Products Corporation issued 12,000 shares of its $10 par value stock to acquire the net assets of Steel Company. Underlying book value
and fair value information for the balance sheet items of Steel at the time of acquisition follow:
Balance Sheet Item
Book Value
Fair Value
$ 60,000
$ 60,000
100,000
100,000
Inventory (LIFO basis)
60,000
115,000
Land
50,000
70,000
400,000
350,000
Less: Accumulated Depreciation
(150,000)
—
Total Assets
$520,000
$695,000
Accounts Payable
$ 10,000
$ 10,000
Bonds Payable
200,000
180,000
Common Stock ($5 par value)
150,000
Additional Paid-In Capital
70,000
Retained Earnings
90,000
Cash
Accounts Receivable
Buildings & Equipment
Total Liabilities & Equities
$520,000
Steel shares were selling at $18 and Pure Products shares were selling at $50 just before the merger announcement. Additional cash payments made by Pure
Products in completing the acquisition were
Finder’s fee paid to firm that located Light Steel
$10,000
Audit fee for stock issued by Pure Products
3,000
Stock registration fee for new shares of Pure Products
5,000
Legal fees paid to assist in transfer of net assets
9,000
Cost of SEC registration of Pure Products shares
1,000
Required
Prepare all journal entries to record the business combination on Pure Products’ books.
P1–35
Purchase at More than Book Value
LO 1–5
Pamrod Manufacturing acquired all the assets and liabilities of Stafford Industries on January 1, 20X2, in exchange for 4,000 shares of Pamrod’s $20 par value
common stock. Balance sheet data for both companies just before the merger are given as follows:
Pamrod shares were selling for $150 on the date of acquisition.
page 42
Required
Prepare the following:
a.
Journal entries to record the acquisition on Pamrod’s books.
b.
A balance sheet for the combined enterprise immediately following the business combination.
P1–36
Business Combination
LO 1–5
Following are the balance sheets of Power Boogie Musical Corporation and Shoot-Toot Tuba Company as of December 31, 20X5.
POWER BOOGIE MUSICAL CORPORATION
Balance Sheet
December 31, 20X5
Assets
Liabilities & Equities
Cash
23,000
Accounts Payable
Accounts Receivable
85,000
Notes Payable
Allowance for Uncollectible Accounts
(1,200)
Mortgage Payable
200,000
Inventory
192,000
Bonds Payable
200,000
Plant & Equipment
980,000
Capital Stock ($10 par)
500,000
(160,000)
Premium on Capital Stock
Accumulated Depreciation
$
Other Assets
14,000
Total Assets
$1,132,800
Retained Earnings
Total Liabilities & Equities
$
48,000
65,000
1,000
118,800
$1,132,800
SHOOT-TOOT TUBA COMPANY
Balance Sheet
December 31, 20X5
Assets
Cash
Accounts Receivable
Liabilities & Equities
$ 300
17,000
Accounts Payable
Notes Payable
$ 8,200
10,000
Allowance for Uncollectible Accounts
Inventory
(600)
78,500
Plant & Equipment
Accumulated Depreciation
Mortgage Payable
50,000
Bonds Payable
100,000
451,000
Capital Stock ($50 par)
100,000
(225,000)
Premium on Capital Stock
150,000
Retained Earnings
(71,200)
Total Liabilities & Equities
$347,000
Other Assets
25,800
Total Assets
$347,000
In preparation for a possible business combination, a team of experts from Power Boogie Musical made a thorough examination and audit of Shoot-Toot Tuba. They
found that Shoot-Toot’s assets and liabilities were correctly stated except that they estimated uncollectible accounts at $1,400. The experts also estimated the market
value of the inventory at $35,000 and the market value of the plant and equipment at $500,000. The business combination took place on January 1, 20X6, and on that
date Power Boogie Musical acquired all the assets and liabilities of Shoot-Toot Tuba. On that date, Power Boogie’s common stock was selling for $55 per share.
Required
Record the combination on Power Boogie’s books assuming that Power Boogie issued 9,000 of its $10 par common shares in exchange for Shoot-Toot’s assets and
liabilities.
P1–37
Combined Balance Sheet
LO 1–5
Pumpworks Inc. and Seaworthy Rope Company agreed to merge on January 1, 20X3. On the date of the merger agreement, the companies reported the following
data:
page 43
Pumpworks has 10,000 shares of its $20 par value shares outstanding on January 1, 20X3, and Seaworthy has 4,000 shares of $5 par value stock outstanding. The
market values of the shares are $300 and $50, respectively.
Required
a.
Pumpworks issues 700 shares of stock in exchange for all of Seaworthy’s net assets. Prepare a balance sheet for the combined entity immediately following the
merger.
b.
Prepare the stockholders’ equity section of the combined company’s balance sheet, assuming Pumpworks acquires all of Seaworthy’s net assets by issuing
1.
1,100 shares of common.
2.
1,800 shares of common.
3.
3,000 shares of common.
P1–38
Incomplete Data
LO 1–5
On January 1, 20X2, Plend Corporation acquired all of Stork Corporation’s assets and liabilities by issuing shares of its common stock. Partial balance sheet data for
the companies prior to the business combination and immediately following the combination are as follows:
Plend Corp.
Stork Corp.
Book Value
Book Value
$ 40,000
$ 10,000
Accounts Receivable
60,000
30,000
88,000
Inventory
50,000
35,000
96,000
300,000
110,000
430,000
Cash
Buildings & Equipment (net)
Combined Entity
$
Goodwill
50,000
?
Total Assets
$450,000
$185,000
Accounts Payable
$ 32,000
$ 14,000
150,000
70,000
Bonds Payable
Bond Premium
$
?
$
46,000
220,000
6,000
Common Stock, $5 par
6,000
100,000
40,000
126,000
Additional Paid-In Capital
65,000
28,000
247,000
Retained Earnings
97,000
33,000
?
$450,000
$185,000
Total Liabilities & Equities
$
?
Required
a.
What number of shares did Plend issue to acquire Stork’s assets and liabilities?
b.
What was the total market value of the shares issued by Plend?
c.
What was the fair value of the inventory held by Stork at the date of combination?
d.
What was the fair value of the identifiable net assets held by Stork at the date of combination?
e.
What amount of goodwill, if any, will be reported by the combined entity immediately following the combination?
f.
What balance in retained earnings will the combined entity report immediately following the combination?
g.
page 44
If the depreciable assets held by Stork had an average remaining life of 10 years at the date of acquisition, what amount of depreciation expense will be reported
on those assets in 20X2?
P1–39
Incomplete Data Following Purchase
LO 1–5
On January 1, 20X1, Palpha Corporation acquired all of Stravo Company’s assets and liabilities by issuing shares of its $3 par value stock to the owners of Stravo
Company in a business combination. Palpha also made a cash payment for stock issue costs. Partial balance sheet data for Palpha and Stravo, before the cash
payment and issuance of shares, and a combined balance sheet following the business combination are as follows:
Required
a.
What number of its $5 par value shares did Stravo have outstanding at January 1, 20X1?
b.
Assuming that all of Stravo’s shares were issued when the company was started, what was the price per share received at the time of issue?
c.
How many shares of Palpha were issued at the date of combination?
d.
What amount of cash did Palpha pay as stock issue costs?
e.
What was the total market value of Palpha’s shares issued at the date of combination?
f.
What was the fair value of Stravo’s inventory at the date of combination?
g.
What was the fair value of Stravo’s net assets at the date of combination?
h.
What amount of goodwill, if any, will be reported in the combined balance sheet following the combination?
P1–40
Comprehensive Business Combination
LO 1–5
Pintime Industries Inc. entered into a business combination agreement with Sydrolized Chemical Corporation (SCC) to ensure an uninterrupted supply of key raw
materials and to realize certain economies from combining the operating processes and the marketing efforts of the two companies. Under the terms of the
agreement, Pintime issued 180,000 shares of its $1 par common stock in exchange for all of SCC’s assets and liabilities. The Pintime shares then were distributed to
SCC’s shareholders, and SCC was liquidated.
page 45
Immediately prior to the combination, SCC’s balance sheet appeared as follows, with fair values also indicated:
Book Values
Fair Values
Assets
Cash
$
28,000
$
28,000
Accounts Receivable
258,000
Less: Allowance for Bad Debts
(6,500)
Inventory
381,000
395,000
Long-Term Investments
150,000
175,000
55,000
100,000
130,000
63,000
Plant & Equipment
2,425,000
2,500,000
Less: Accumulated Depreciation
(614,000)
Land
Rolling Stock
251,500
Patents
125,000
500,000
95,800
100,000
$3,027,300
$4,112,500
$
137,200
$ 137,200
Mortgages Payable
500,000
520,000
Equipment Trust Notes
100,000
95,000
1,000,000
950,000
Special Licenses
Total Assets
Liabilities
Current Payables
Debentures Payable
Less: Discount on Debentures
Total Liabilities
(40,000)
$1,697,200
$1,702,200
Stockholders’ Equity
Common Stock ($5 par)
600,000
Additional Paid-In Capital from Common Stock
500,000
Additional Paid-In Capital from Retirement of Preferred Stock
22,000
Retained Earnings
220,100
Less: Treasury Stock (1,500 shares)
(12,000)
Total Liabilities & Equity
$3,027,300
Immediately prior to the combination, Pintime’s common stock was selling for $14 per share. Pintime incurred direct costs of $135,000 in arranging the business
combination and $42,000 of costs associated with registering and issuing the common stock used in the combination.
Required
a.
Prepare all journal entries that Pintime should have entered on its books to record the business combination.
b.
Present all journal entries that should have been entered on SCC’s books to record the combination and the distribution of the stock received.
1
“PNC Shakes Up Banking Sector; Investors Exit,” The Wall Street Journal, January 30, 2002, p. C2.
2
Dennis K. Berman and Jason Singer, “Big Mergers Are Making a Comeback as Companies, Investors Seek
Growth,” The Wall Street Journal, November 5, 2005, p. A1.
3
Dennis K. Berman and Jason Singer, “Blizzard of Deals Heralds an Era of Megamergers,” The Wall Street
Journal, June 27, 2006, p. A1.
4
ASC 805-10-65-1
5
Majority ownership is generally a sufficient but not a necessary condition for the indicated treatment.
Unlike the corporate case, percentage ownership does not fully describe the nature of a beneficial interest
in a partnership. Investments in partnerships are discussed in later chapters.
6
To view a video explanation of this topic, visit advancedstudyguide.com.
7
Journal entries used in the text to illustrate the various accounting procedures are numbered sequentially
within individual chapters for easy reference. Each journal entry number appears only once in a chapter.
8
However, the FASB decided in ASC 805 to focus directly on the value of the consideration given rather than
just using it to impute a fair value for the acquiree as a whole. In some cases, the value of the
consideration given may be difficult to determine, or there may be no exchange, and valuation is better based
on the value of the acquirer’s interest in the acquiree or other valuation techniques. ASC 820 provides a
framework for applying fair value measurements in accounting.
9
An operating segment is defined in ASC 280-10-50. Whereas U.S. GAAP assigns goodwill to reporting units,
IFRS assigns goodwill to cash-generating units (GCU).
10
ASU 2014-02 grants private companies the option of amortizing goodwill on a straightline basis over a
period not to exceed 10 years.
11
12
See Chapter 4 for a more detailed discussion of this topic.
The treatment of contingent consideration under IFRS is slightly different. Although contingent
consideration classified as an asset or liability will likely be a financial instrument measured at fair
value with gains or losses recognized in profit or loss, if the asset or liability is not a financial
instrument, it is accounted for in accordance with the standard provisions for that class of asset or
liability (i.e., not necessarily at fair value).
page 46
2
Reporting Intercorporate Investments
and Consolidation of Wholly Owned
Subsidiaries with No Differential
Multicorporate Entities
Business Combinations
Consolidation Concepts and Procedures
Intercompany Transfers
Additional Consolidation Issues
Multinational Entities
Reporting Requirements
Partnerships
Governmental and Not-for-Profit Entities
Corporations in Financial Difficulty
BERKSHIRE HATHAWAY’S MANY INVESTMENTS
As of this writing (February 2017), Warren Buffett is the third-richest man in the world, worth a staggering $60 billion (not including the $21.5 billion he has
already given away). He is also the chairman, CEO, and primary shareholder of Berkshire Hathaway Inc. Over the past 51 years, Berkshire has grown at an
average rate of 21.6 percent annually. Warren Buffett has achieved this success through his unparalleled business sense regarding investments and
acquisitions of other companies.
Berkshire Hathaway was originally a textile manufacturing company. In 1962, Warren Buffett and his partners began buying large blocks of Berkshire
stock. Within five years, Buffett began expanding into the insurance industry, and in 1985 the last of Berkshire’s textile operations was shut down. In the late
1970s, Berkshire began acquiring stock in GEICO insurance and in January 1996 bought GEICO outright. While Berkshire has extensive insurance holdings,
it has not focused its investment activities solely on insurance. Since Buffett took the helm in the 1960s, Berkshire has made many acquisitions. Look at the
list of selected Berkshire holdings as of the end of 2016. Do you recognize any of these companies?
Each item in Berkshire’s portfolio has to be accounted for individually. For example, Comdisco Holdings and Graham Holdings Company are accounted
for as equity method investments, while Walmart and American Express are classified as available-for-sale investments. Berkshire consolidates the fully
owned companies such as Wesco Financial and See’s Candies. In addition, companies like GEICO have many subsidiaries of their own. As you can imagine,
accounting for investments at Berkshire can be very complex. This chapter focuses on issues related to the accounting for investments.
page 47
BERKSHIRE HATHAWAY SELECTED HOLDINGS
(AS OF 12/31/2016)
Examples of fully-owned subsidiaries:
Acme Brick Company
Benjamin Moore & Co.
Dairy Queen
Duracell
Fruit of the Loom Companies
GEICO Auto Insurance
NetJets®
Pampered Chef®
RC Willey Home Furnishings
See’s Candies
Examples of partially-owned companies with ownership greater than 20 percent:
% Owned
Market Value (in millions)
USG Corporation
27.1
$ 1,167
Kraft Heinz Co.
26.8
29,122
Examples of partially-owned companies with ownership less than 20 percent:
% Owned
Market Value (in millions)
Costco Wholesale Corporation
1.0
Walmart
0.4
852
Visa, Inc.
0.5
885
General Motors Company
3.4
1,851
Apple, Inc.
0.3
1,854
Deere & Company
6.7
2,277
Moody’s Corporation
12.9
2,565
Phillips 66
15.6
6,679
American Express Company
16.6
11,651
IBM Corp.
8.5
14,402
The Coca-Cola Co.
9.3
16,580
Wells Fargo & Co.
9.5
27,146
$
702
http://www.berkshirehathaway.com/subs/sublinks.html
http://www.cnbc.com/berkshire-hathaway-portfolio/
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO 2–1
Understand and explain how ownership and control can influence the accounting for investments in common stock.
LO 2–2
Prepare journal entries for investments carried at fair value.
LO 2–3
Prepare journal entries for investments using the equity method.
LO 2–4
Understand and explain differences in accounting for investments carried at fair value and investments accounted for using the equity
method.
LO 2–5
Make calculations and prepare basic consolidation entries for a simple consolidation.
LO 2–6
Prepare a consolidation worksheet.
ACCOUNTING FOR INVESTMENTS IN COMMON STOCK
L O 2 –1
Understand and explain how ownership and control can influence the accounting for investments in common stock.
Companies acquire ownership interests in other companies for a variety of reasons. For example, some companies invest in other companies simply to earn a
favorable return by taking advantage of the future earnings potential of their investees. Other reasons for acquiring interests in other entities include (1)
gaining voting control, (2) entering new product markets by purchasing companies already established in those areas, (3) ensuring a supply of raw materials
or other production inputs, (4) ensuring a customer for production output, (5) gaining economies associated with greater size, (6) diversifying page 48
operations, (7) obtaining new technology, (8) lessening competition, and (9) limiting risk.
The approach used to account for investments in common stock depends, in part, on the level of influence or control that the investor is able to exercise
over the investee. If the investment level does not provide the investor with significant influence with the investee, then the investment will normally be
reported on the investor’s balance sheet at fair value. If the investment level does provide the investor with significant influence with the investee, then the
investor will use the equity method to account for the investment. If the investor company acquires more than 50 percent of the investee’s voting shares, it is
required to consolidate the investee company; in which case, the investment account would not appear on the consolidated balance sheet. Essentially,
consolidation replaces the investment account with all of the detail on the subsidiary’s balance sheet. Figure 2–1 summarizes how the reporting of
intercorporate investments in common stock changes with the investor’s level of ownership and influence. 1
F I G U R E 2 –1
Financial Reporting Basis by Level of Common Stock Ownership
Investments in equity securities where the investor does not have significant influence are carried at fair value on the balance sheet if the equity
securities have readily determinable fair values. These securities must be remeasured to fair value at the end of each period, and the unrealized gain or loss is
recognized in income under ASC 321. For securities carried at fair value, the investor also recognizes income from the investment when dividends are
declared by the investee.
The equity method is required for external reporting of investments in equity securities when the investor has the ability to exercise significant influence
over the operating and financial policies of the investee and consolidation is not appropriate. This method is used most often when one company holds 20
percent or more of another company’s common stock. Under the equity method, the investor recognizes income from the investment as the investee earns
the income. Instead of combining the individual assets, liabilities, revenues, and expenses of the investee with those of the investor, as in consolidation, the
investment is reported as one line in the investor’s balance sheet, and income recognized from the investee is reported as one line in the
page 49
investor’s income statement. The investment represents the investor’s share of the investee’s net assets, and the income recognized is the
investor’s share of the investee’s net income.
For financial reporting, consolidated financial statements that include both the investor and the investee must be presented if the investor can exercise
control over the investee. Consolidation involves combining for financial reporting the individual assets, liabilities, revenues, and expenses of two or more
related companies as if they were part of a single company. This process includes the elimination of all intercompany ownership and activities. Consolidation
normally is appropriate when one company, referred to as the parent, controls another company, referred to as a subsidiary. We discuss the specific
requirements for consolidation later in this chapter. A subsidiary that is not consolidated with the parent is referred to as an unconsolidated subsidiary and is
shown as an investment on the parent’s balance sheet. Under current accounting standards, most subsidiaries are consolidated. When intercorporate
investments are consolidated for financial reporting, the investment and related income accounts are eliminated in preparing the consolidated financial
statements. Nevertheless, the parent must still account for the investments on its books. Parent companies have the choice of accounting for investments in
consolidated subsidiaries on their books by using the equity method or by carrying these investments at historical cost. 2
This chapter follows Figure 2–1 in summarizing the accounting for investments in other companies. First we discuss accounting for securities carried at
fair value and accounting for securities using the equity method. We then conclude the chapter by introducing the preparation of consolidated financial
statements using the most simple consolidation scenario (when a subsidiary is wholly owned and it is either created or purchased for an amount exactly equal
to the book value of the subsidiary’s net assets). Since consolidation is a major topic of this textbook, we use a building block approach to our coverage of
consolidation in Chapters 2 through 5, summarized in Figure 2-2. Chapter 3 explains how the basic consolidation process changes when the parent company
owns less than 100 percent of the subsidiary. Chapter 4 shows how the consolidation process differs when the parent company acquires 100 percent of a
subsidiary for an amount greater (or less) than the book value of the subsidiary’s net assets. Finally, Chapter 5 presents the most complex consolidation
scenario (where the parent owns less than 100 percent of the subsidiary’s outstanding voting stock and the acquisition price is not equal to the book value of
the subsidiary’s net assets). Chapters 6 through 10 delve into asset transfers among members of the same consolidated group of companies and additional
details related to consolidation.
F I G U R E 2 –2
Summary of Consolidation Coverage in Chapters 2–5
page 50
SECURITIES CARRIED AT FAIR VALUE
L O 2 –2
Prepare journal entries to account for investments carried at fair value.
Intercorporate investments are typically reported on the balance sheet at fair value when the investor lacks the ability either to control or to exercise
significant influence over the investee. The inability of an investor to exercise either control or significant influence over an investee may result from the size
of the investment, usually at common stock ownership levels of less than 20 percent. In some situations, other factors, such as the existence of a majority
shareholder, prevent the investor from exercising significant influence regardless of the size of the investment. (See Appendix 2A for a discussion of
additional considerations that may help determine if the investor is able to exercise significant influence and should therefore use the equity method of
accounting for an investment.)
Accounting Procedures for Securities Carried at Fair Value
For equity investments where significant influence is not present, the investor records its investment in common stock at the total cost incurred in making
the purchase. Subsequently, income from the investment is recognized by the investor as dividends are declared by the investee. Once the investee declares a
dividend, the investor has a legal claim against the investee for a proportionate share of the dividend, and realization of the income is considered certain
enough to be recognized. Recognition of investment income before a dividend declaration is considered inappropriate because the investee’s income is not
available to the owners until a dividend is declared. At each subsequent balance sheet date, these securities must be remeasured to fair value as of the end of
each period, and the unrealized gain or loss is recognized in income.
To illustrate the accounting procedures for securities carried at fair value, assume that Ajax Corporation purchases 40 percent of Barclay Company’s
common stock on January 1, 20X1, for $200,000. Ajax prepares financial statements at the end of each calendar quarter. On March 1, 20X1, Ajax receives a
cash dividend of $1,500 from Barclay. On March 31, 20X1, Ajax determines the fair value of its investment in Barclay to be $207,000. During the first
quarter of 20X1, Ajax records the following entries on its books in relation to its investment in Barclay:
(1)
Investment in Barclay Stock
200,000
Cash
200,000
Record purchase of Barclay Company stock.
(2)
Cash
1,500
Dividend Income
1,500
Record dividend income from Barclay Company.
(3)
Investment in Barclay Stock
Unrealized Gain on Barclay Stock (Income Statement)
7,000
7,000
Record increase in fair value of Barclay stock.
Changes in the Number of Shares Held
Changes in the number of investment shares resulting from stock dividends, stock splits, or reverse splits receive no formal recognition in the accounts of
the investor. The carrying value of the investment before the stock dividend or split becomes the carrying amount of the new, higher or lower number of
shares. Purchases and sales of shares, of course, do require journal entries but do not result in any unusual difficulties for investments carried at fair value.
Purchases of Additional Shares
The purchase of additional shares of a company already held is recorded at the total cost incurred in making the additional purchase in the same way as an
initial purchase of shares. The investor’s new percentage ownership of the investee is then calculated, and other evidence, if available, is evaluated page 51
to determine whether the total investment still should be carried at fair value or if the investor should switch to the equity method at the date additional shares
are acquired.
Sales of Shares
If a company sells all or part of an intercorporate investment in stock, the transaction is accounted for in the same manner as the sale of any other asset. A
gain or loss on the sale is recognized for the difference between the proceeds received and the carrying amount of the investment sold.
If shares of the stock have been purchased at more than one price, a determination must be made at the time of sale as to which of the shares have been
sold. The specific shares sold may be identified through segregation, numbered stock certificates, or other means. When specific identification is impractical,
either a FIFO or weighted-average cost flow assumption may be used. However, the weighted-average method is seldom used in practice because it is not
acceptable for tax purposes.
THE EQUITY METHOD
L O 2 –3
Prepare journal entries for investments using the equity method.
The equity method of accounting for intercorporate investments in common stock is intended to reflect the investor’s changing equity or interest in the
investee. This method is a rather curious one in that the balance in the investment account generally does not reflect either cost or market value, and it does
not necessarily represent a pro rata share of the investee’s book value. Instead, the investment is recorded at the initial purchase price and adjusted each
period for the investor’s share of the investee’s profits or losses and the dividends declared by the investee.
Use of the Equity Method
ASC 323 requires that the equity method be used for reporting investments in common stock of the following:
1. Corporate joint ventures. A corporate joint venture is a corporation owned and operated by a small group of businesses, none of which owns a majority of the
joint venture’s common stock.
2. Companies in which the investor’s voting stock interest gives the investor the “ability to exercise significant influence over operating and financial policies” of that
company.
The second condition is the broader of the two and establishes the “significant influence” criterion. Because assessing the degree of influence may be
difficult in some cases, ASC 323 establishes a 20 percent rule. In the absence of evidence to the contrary, an investor holding 20 percent or more of an
investee’s voting stock is presumed to have the ability to exercise significant influence over the investee. On the other hand, an investor holding less than 20
percent of an investee’s voting stock is presumed not to have the ability to exercise significant influence in the absence of evidence to the contrary.
In most cases, an investment of 20 percent or more in another company’s voting stock is reported under the equity method. Notice, however, that the 20
percent rule does not apply if other evidence is available that provides a better indication of the ability or inability of the investor to significantly influence the
investee.
Regardless of the level of ownership, the equity method is not appropriate if the investor’s influence is limited by circumstances other than stock
ownership, such as the existence of a majority shareholder (i.e., two owners with a 25/75 split) or severe restrictions placed on the availability of a foreign
investee’s earnings or assets by a foreign government. (See Appendix 2A for a discussion of additional considerations relating to the equity method.)
page 52
Investor’s Equity in the Investee
Under the equity method, the investor records its investment at the original cost. This amount is adjusted periodically for changes in the investee’s
stockholders’ equity occasioned by the investee’s profits, losses, and dividend declarations. The effect of the investee’s income, losses, and dividends on the
investor’s investment account and other accounts can be summarized as follows:
Reported by Investee
Effect on Investor’s Accounts
Net income
Record income from investment
Increase investment account
Net loss
Record loss from investment
Decrease investment account
Dividend declaration
Record asset (cash or receivable)
Decrease investment account
Recognition of Income
Under the equity method, the investor’s income statement includes the investor’s proportionate share of the investee’s income or loss each period. The
carrying amount of the investment is adjusted by the same amount to reflect the change in the net assets of the investee resulting from the investee’s income.
To illustrate, assume that ABC Company acquires significant influence over XYZ Company by purchasing 20 percent of XYZ’s common stock for
$100,000 at the beginning of the year.
(4)
Investment in XYZ Company Stock
100,000
Cash
100,000
Record purchase of XYZ Company stock.
XYZ reports income of $60,000 for the year. ABC records its 20 percent share of XYZ’s income ($12,000) in an account called “Income from XYZ
Company” as follows:
(5)
Investment in XYZ Company Stock
12,000
Income from XYZ Company
12,000
Record income from XYZ Company ($60,000 × 0.20).
This entry may be referred to as the equity accrual and normally is made as an adjusting entry at the end of the period. If the investee reports a loss for
the period, the investor recognizes its share of the loss and reduces the carrying amount of the investment by that amount.
Because of the ability to exercise significant influence over the policies of the investee, realization of income from the investment is considered to be
sufficiently ensured to warrant recognition by the investor as the investee earns the income. This differs from the case in which the investor does not have
the ability to significantly influence the investee and the investment must be reported using the cost method; in that case, income from the investment is
recognized only upon declaration of a dividend by the investee.
Recognition of Dividends
Dividends from an investment are not recognized as income under the equity method because the investor’s share of the investee’s income is recognized as
the investee earns it. Instead, the investee’s dividends are viewed as distributions of previously recognized income that already has been capitalized in the
carrying amount of the investment. The investor must consider investee dividends declared as a reduction in its equity in the investee and, page 53
accordingly, reduce the carrying amount of its investment. In effect, all dividends from the investee are treated as liquidating dividends under the
equity method. Thus, if ABC Company owns 20 percent of XYZ Company’s common stock and XYZ declares a $20,000 dividend, the following entry is
recorded on ABC’s books to record its share of the dividend:
(6)
Dividends Receivable
Investment in XYZ Company Stock
4,000
4,000
Record dividend from XYZ Company ($20,000 × 0.20).
The following T-accounts summarize all of the normal equity-method entries (journal entries 4–6) on the investor’s books:
Carrying Amount of the Investment and Investment Income under the Equity
Method
The ending balance in the T-account above for “Investment in XYZ Company” summarizes ABC’s ownership of the net assets of XYZ Company at the end
of the period. This amount appears on ABC’s balance sheet. The ending balance in the T-account above for “Income from XYZ Company” summarizes
ABC’s share of XYZ Company’s income for the period. This amount appears in ABC’s income statement for the period.
Because the investment account on the investor’s books under the equity method is adjusted for the investor’s share of the investee’s income or losses
and dividends, the carrying amount of the investment usually is not the same as the original cost to the investor. Only if the investee pays dividends in the
exact amount of its earnings will the carrying amount of the investment subsequent to acquisition be equal to its original cost.
Changing to the Equity Method at an Interim Date
An investment in common stock of an investee that was previously accounted for on other than the equity method may become qualified for use of the
equity method by an increase in the level of ownership. As described in ASC 323, this could occur as a result of acquisition of additional voting stock by the
investor, acquisition or retirement of voting stock by the investee, or other transactions. At the time the investment qualifies for use of the equity method, the
investor shall add the cost of acquiring the additional interest in the investee (if any) to the current basis of the investor’s previously held interest and adopt
the equity method of accounting as of the date the investment becomes qualified for equity method accounting. The accounting from this date forward will
be similar to the procedures illustrated below for acquiring an equity method investment at an interim date.
Acquisition at Interim Date
When a company purchases an investment, the investor begins accruing income from the investee under the equity method at the date of acquisition. The
investor may not accrue income earned by the investee before the acquisition date of the investment. When the purchase occurs between balance sheet dates,
the amount of income earned by the investee from the date of acquisition to the end of the fiscal period may need to be estimated by the investor in page 54
recording the equity accrual. However, since “significant influence” is a requirement for using the equity method, it is likely that the investor will
be able to simply ask for the actual post purchase financial results from the investee.
To illustrate, assume that ABC acquires 20 percent of XYZ’s common stock on October 1 for $100,000. Also assume XYZ earns income of $60,000
uniformly throughout the year, and that XYZ also declared and paid dividends of $20,000 during December. The carrying amount of the investment is
increased by $3,000, which represents ABC’s share of XYZ’s net income earned between October 1 and December 31 (1/4 of the year), and is decreased by
$4,000 as a result of dividends declared at year-end (resulting in a net decrease of $1,000 since the time of the stock purchase). 3
Changes in the Number of Shares Held
Some changes in the number of common shares held by an investor are handled easily under the equity method, but others require a bit more attention. No
formal accounting recognition is required on the books of the investor as a result of a stock dividend, split, or reverse split. On the other hand, purchases and
sales of shares do require formal recognition.
Purchases of Additional Shares
A purchase of additional shares of a common stock already held by an investor and accounted for using the equity method simply involves adding the cost of
the new shares to the investment account and applying the equity method in the normal manner from the date of acquisition forward. The new and old
investments in the same stock are combined for financial reporting purposes. Income accruing to the new shares can be recognized by the investor only
from the date of acquisition forward.
FYI
Figure 2–1 indicates that once a company owns more than 50 percent of the outstanding voting stock of an
investee company, the parent company can account for the investment using the cost method on its own books
because the investment account is eliminated in the consolidation process. Berkshire Hathaway’s 2010 Form
10-K indicates: “As a result of our acquisition of the remaining outstanding stock of BNSF on February
12, 2010, we discontinued the use of the equity method and since that date, BNSF’s accounts have been
consolidated in our financial statements.”
To illustrate, assume that ABC Company purchases 20 percent of XYZ Company’s common stock on January 2, 20X1, for $100,000, and another 10
percent on July 1, 20X1, for $51,500, and that the stock purchases represent 20 percent and 10 percent, respectively, of the book value of XYZ’s net assets.
If XYZ earns income of $25,000 from January 2 to June 30 and earns $35,000 from July 1 to December 31, the total income recognized in 20X1 by ABC
from its investment in XYZ is $15,500, computed as follows:
Income, January 2 to June 30: $25,000 × 0.20
$ 5,000
Income, July 1 to December 31: $35,000 × 0.30
10,500
Investment Income, 20X1
$15,500
page 55
If XYZ declares and pays a $10,000 dividend on January 15 and again on July 15, ABC reduces its investment account by $2,000 ($10,000 × 0.20) on
January 15 and by $3,000 ($10,000 × 0.30) on July 15. Thus, the ending balance in the investment account at the end of the year is $162,000, computed as
follows:
Sales of Shares
The sale of all or part of an investment in common stock carried using the equity method is treated the same as the sale of any noncurrent asset. First, the
investment account is adjusted to the date of sale for the investor’s share of the investee’s current earnings. Then a gain or loss is recognized for the
difference between the proceeds received and the carrying amount of the shares sold.
If only part of the investment is sold, the investor must decide whether to continue using the equity method to account for the remaining shares or to
make a change and carry the investment at fair value from this date forward. The choice is based on evidence available after the sale as to whether the
investor still is able to exercise significant influence over the investee. If the equity method is no longer appropriate after the date of sale, the remaining
investment is carried on the balance sheet at fair value with any unrealized holding gains or losses recognized in income each period from the date of sale
forward.
FYI
The summary of Berkshire Hathaway’s holdings at the beginning of the chapter lists its stake in Moody’s
at 12.9%. Its holdings had previously exceeded 20%. However, Berkshire’s 2009 10-K indicates: “As a
result of a reduction in our ownership of Moody’s in July of 2009, we discontinued the use of the equity
method as of the beginning of the third quarter of 2009.”
INVESTMENTS CARRIED AT FAIR VALUE AND INVESTMENTS ACCOUNTED FOR
USING THE EQUITY METHOD 4
L O 2 –4
Understand and explain differences in accounting for investments carried at fair value and investments accounted for using the equity method.
Figure 2–3 summarizes some of the key features of accounting for intercorporate investments carried at fair value and investments accounted for using the
equity method. When an investor lacks significant influence with an investee, it is assumed that the investor had no influence over the amount and timing of
any declaration of dividends by the investee. It is also assumed that the fair value of an equity security at any point in time is established in a ready market
based on all known information and expectations that exist in the market at that date. Therefore, the investor reports in earnings a proportionate share of all
dividends declared and also recognizes all unrealized gains and losses in income.
The significant influence criterion required for the equity method considers that the declaration of dividends by the investee can be influenced by the
investor. Recognizing equity-method income from the investee without regard to investee dividends provides protection against manipulating the investor’s
net income by influencing investee dividend declarations. On the other hand, the equity method is sometimes criticized because the asset valuation departs
from historical cost but stops short of a market value approach. Instead, the carrying amount of the investment is composed of a number of components and
is not similar to the valuation of any other assets.
page 56
FIGURE 2–3
Summary Comparison of investments Carried at Fair Value and Equity Methods
Item
Carried at Fair Value
Equity Method
Recorded amount of
investment at
date of
acquisition
Original cost
Original cost
Usual carrying
amount of
investment
subsequent to
acquisition
Fair value at balance sheet date
Original cost increased (decreased) by
investor’s share of investee’s income (loss)
and decreased by investor’s share of
investee’s dividends
Income recognition
by investor
Investor’s share of investee’s Investor’s share of investee’s earnings since
dividends plus unrealized
acquisition, whether distributed or not
holding gains or losses during
the period
Investee dividends
Recognized as income
Reduction of investment
Over the years, there has been considerable criticism of the use of the equity method as a substitute for the consolidation of certain types of subsidiaries.
Although the equity method has been viewed as a one-line consolidation, the amount of detail reported is considerably different under the equity method
than with consolidation. For example, an investor would report the same equity-method income from the following two investees even though their income
statements are quite different in composition:
Investee 1
Investee 2
Sales
$ 50,000
$ 500,000
Operating Expenses
(30,000)
(620,000)
Operating Income (Loss)
$ 20,000
$(120,000)
Gain on Sale of Land
Net Income
140,000
$ 20,000
$
20,000
Similarly, an investment in the stock of another company is reported under the equity method as a single amount in the investor’s balance sheet regardless of
the investee’s asset and capital structure.
OVERVIEW OF THE CONSOLIDATION PROCESS
L O 2 –5
Make calculations and prepare basic consolidation entries for a simple consolidation.
The consolidation process adds together the financial statements of two or more legally separate companies, creating a single set of financial statements.
Chapters 2 through 5 discuss the specific procedures used to produce consolidated financial statements in considerable detail. An understanding of the
procedures is important because they facilitate the accurate and efficient preparation of consolidated statements. However, the focus should continue to be on
the end product—the financial statements. The procedures are intended to produce financial statements that appear as if the consolidated companies are
actually a single company.
The separate financial statements of the companies involved serve as the starting point each time consolidated statements are prepared. These separate
statements are added together, after some adjustments, to generate consolidated financial statements. The adjustments relate to intercompany transactions and
holdings. Although the individual companies within a consolidated entity may legitimately report sales and receivables or payables to one another, the
consolidated entity as a whole must report transactions only with parties outside the consolidated entity and receivables from or payables to
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external parties. Thus, the adjustments required as part of the consolidation process aim at ensuring that the consolidated financial statements
are presented as if they were the statements of a single enterprise.
CONSOLIDATION PROCEDURES FOR WHOLLY OWNED SUBSIDIARIES THAT ARE
CREATED OR PURCHASED AT BOOK VALUE
We begin preparing consolidated financial statements with the books of the individual companies that are to be consolidated. Because the consolidated entity
has no books, all amounts in the consolidated financial statements originate on the books of the parent or a subsidiary or in the consolidation worksheet.
The term subsidiary has been defined as “an entity . . . in which another entity, known as its parent, holds a controlling financial interest” (ASC 810). A
parent company does not need to hold all of a corporate subsidiary’s common stock, but at least majority ownership is normally required for the presentation
of consolidated financial statements. Most, but not all, corporate subsidiaries are wholly owned by their parents.
Because most subsidiaries are wholly owned, this chapter begins the in-depth examination of consolidation procedures for wholly owned subsidiaries.
Moreover, we begin with the most basic consolidation scenario when the subsidiary is either created by the parent or purchased for an amount exactly equal
to the book value of the subsidiary’s net assets. This assumption simplifies the consolidation because there is no differential. We start with basic consolidation
procedures applied to the preparation of a consolidated balance sheet immediately following the establishment of a parent–subsidiary relationship, either
through creation or acquisition of the subsidiary. Then we introduce the use of a simple consolidation worksheet for the balance sheet only. The chapter then
moves to the preparation of a full set of consolidated financial statements in subsequent periods and the use of a three-part worksheet designed to facilitate
the preparation of a consolidated income statement, retained earnings statement, and balance sheet.
CONSOLIDATION WORKSHEETS
L O 2 –6
Prepare a consolidation worksheet.
The consolidation worksheet provides a mechanism for efficiently combining the accounts of the separate companies involved in the consolidation and for
adjusting the combined balances to the amounts that would be reported if all consolidating companies were actually a single company. When consolidated
financial statements are prepared, the account balances are taken from the separate books of the parent and each subsidiary and then placed in the
consolidation worksheet. The consolidated statements are prepared, after adjustments, from the amounts in the consolidation worksheet.
Worksheet Format
In practice, companies use several different worksheet formats for preparing consolidated financial statements. One of the most widely used formats is the
three-part worksheet, consisting of one part for each of three financial statements: (1) the income statement, (2) the statement of retained earnings, and (3)
the balance sheet. In recent years, the retained earnings statement has been dropped by many companies in favor of the statement of changes in
stockholders’ equity. Nevertheless, the information normally found in a retained earnings statement is included in the statement of stockholders’ equity, along
with additional information, and so the three-part worksheet still provides a useful format. Figure 2–4 presents the format for the comprehensive three-part
consolidation worksheet. Specifically, Figure 2–4 illustrates the basic form of a consolidation worksheet. The titles of the accounts of the consolidating
companies are listed in the first column of the worksheet. The account balances from the books or trial balances of the individual companies are page 58
listed in the next set of columns, with a separate column for each company included in the consolidation. Entries are made in the columns labeled
Consolidation Entries to adjust or eliminate balances so that the resulting amounts are those that would appear in the financial statements if all the
consolidating companies actually formed a single company. The balances in the last column are obtained by summing all amounts algebraically across the
worksheet by account. These are the balances that appear in the consolidated financial statements.
F I G U R E 2 –4
Format for Consolidation Worksheet
The top portion of the worksheet is used in preparing the consolidated income statement. All income statement accounts are listed in the order they
normally appear in an income statement. 5 When the income statement portion of the worksheet is completed, a total for each column is entered at the bottom
of the income statement portion of the worksheet. The bottom line in this part of the worksheet shows the parent’s net income, the subsidiary’s net income,
the totals of the debit and credit adjustments for this section of the worksheet, and consolidated net income. The entire bottom line is carried down to the
“net income” line in the retained earnings statement portion of the worksheet immediately below the income statement.
The retained earnings statement section of the worksheet is in the same format as a retained earnings statement, or the retained earnings section of a
statement of stockholders’ equity. Net income and the other column totals from the bottom line of the income statement portion of the worksheet are brought
down from the income statement above. Similarly, the final line in the retained earnings statement section of the worksheet is carried down in its entirety to
the retained earnings line in the balance sheet section.
CAUTION
The most common error students commit in preparing the worksheet is forgetting to carry down the
adjustments when they carry down net income from the income statement to the statement of retained
earnings and when they carry down the retained earnings ending balance in the statement of retained
earnings to the balance sheet.
The bottom portion of the worksheet reflects the balance sheet amounts at the end of the period. 6 The retained earnings amounts appearing in the balance
sheet section of the worksheet are the totals carried forward from the bottom line of the retained earnings statement section. The examples in
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the following sections of this chapter demonstrate the use of the comprehensive three-part consolidation worksheet.
Nature of Consolidation Entries
Consolidation entries are used in the consolidation worksheet to adjust the totals of the individual account balances of the separate consolidating companies
to reflect the amounts that would appear if the legally separate companies were actually a single company. Consolidation entries appear only in the
consolidation worksheet and do not affect the books of the separate companies. These worksheet entries are sometimes called “elimination” entries.
For the most part, companies that are to be consolidated record their transactions during the period without regard to the consolidated entity.
Transactions with related companies tend to be recorded in the same manner as those with unrelated parties, although intercompany transactions may be
recorded in separate accounts or other records may be kept to facilitate the later elimination of intercompany transactions. Each of the consolidating
companies also prepares its adjusting and closing entries at the end of the period in the normal manner. The resulting balances are entered in the consolidation
worksheet and combined to arrive at the consolidated totals. Consolidation entries are used in the worksheet to increase or decrease the combined totals for
individual accounts so that only transactions with external parties are reflected in the consolidated amounts.
Some consolidation entries are required at the end of one period but not at the end of subsequent periods. For example, a loan from a parent to a
subsidiary in December 20X1 and repaid in February 20X2 requires an entry to eliminate the intercompany receivable and payable on December 31, 20X1,
but not at the end of 20X2. Some other consolidation entries need to be placed in the consolidation worksheets each time consolidated statements are
prepared for a period of years. For example, if a parent company sells land to a subsidiary for $5,000 above the original cost to the parent, a worksheet entry
is needed to reduce the basis of the land by $5,000 each time consolidated statements are prepared for as long as an affiliate (an affiliated company) holds
the land. 7 It is important to remember that because consolidation entries are not made on the books of any company, they do not carry over from period to
period.
CONSOLIDATED BALANCE SHEET WITH WHOLLY OWNED SUBSIDIARY
The simplest consolidation setting occurs when the financial statements of related companies are consolidated immediately after a parent-subsidiary
relationship is established through a business combination or the creation of a new subsidiary. We present a series of examples to illustrate the preparation of
a consolidated balance sheet. Consolidation procedures are the same whether a subsidiary is created or acquired. We use the case of an acquired subsidiary to
illustrate the consolidation procedures in the examples that follow. In each example, Peerless Products Corporation purchases all of the common stock of
Special Foods Inc. on January 1, 20X1, and immediately prepares a consolidated balance sheet. Figure 2–5 presents the separate balance sheets of the two
companies immediately before the combination.
In the following discussion, we present all journal entries and worksheet consolidation entries in the text of the chapter. To avoid confusing the
consolidation entries with journal entries that appear on the separate books of the parent or subsidiary, all worksheet consolidation entries appearing in the text
are shaded; journal entries recorded in the books of the parent company are not shaded.
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100 Percent Ownership Acquired at Book Value
In the first example, Peerless acquires all of Special Foods’ outstanding common stock for $300,000, an amount equal to the fair value of Special Foods as a
whole. On the date of combination, the fair values of Special Foods’ individual assets and liabilities are equal to their book values shown in Figure 2–5.
Because Peerless acquires all of Special Foods’ common stock and because Special Foods has only the one class of stock outstanding, the total book value
of the shares acquired equals the total stockholders’ equity of Special Foods ($200,000 + $100,000). The $300,000 of consideration exchanged is equal to
the book value of the shares acquired. This ownership situation can be characterized as follows:
Peerless records the stock acquisition on its books with the following entry on the combination date:
(7)
Investment in Special Foods
300,000
Cash
300,000
Record the purchase of Special Foods stock.
Figure 2–6 presents the separate financial statements of Peerless and Special Foods immediately after the combination. Special Foods’ balance sheet in Figure
2–6 is the same as in Figure 2–5, but Peerless’s balance sheet has changed to reflect the $300,000 reduction in cash and the recording of the investment in
Special Foods stock for the same amount. Note that the $300,000 of cash was paid to the former stockholders of Special Foods, not to the company itself.
Accordingly, that cash is no longer in the consolidated entity. Instead, Peerless’s balance sheet now reflects $300,000 in its Investment in Special Foods
Stock account.
FIGURE 2–5
Balance Sheets of Peerless Products and Special Foods, January 1, 20X1, Immediately
before Combination
Peerless Products
Special Foods
Assets
Cash
$
Accounts Receivable
350,000
$
50,000
75,000
50,000
Inventory
100,000
60,000
Land
175,000
40,000
Buildings & Equipment
800,000
600,000
(400,000)
(300,000)
Accumulated Depreciation
Total Assets
$1,100,000
$ 500,000
$
100,000
$ 100,000
Bonds Payable
200,000
100,000
Common Stock
500,000
200,000
Retained Earnings
300,000
100,000
$1,100,000
$ 500,000
Liabilities & Stockholders’ Equity
Accounts Payable
Total Liabilities & Equity
Basic Consolidation Entry
The basic consolidation entry removes the Investment in Special Foods Stock account and the subsidiary’s stockholders’ equity accounts. Although this
consolidation entry is very simple, to be consistent with the discussion of more complicated examples later in the chapter, we illustrate the thought process in
developing the worksheet entry.
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FIGURE 2–6
Balance Sheets of Peerless Products and Special Foods, January 1, 20X1, Immediately
after Combination
Peerless Products
Special Foods
Assets
Cash
$
Accounts Receivable
50,000
$
50,000
75,000
50,000
Inventory
100,000
60,000
Land
175,000
40,000
Buildings & Equipment
800,000
600,000
(400,000)
(300,000)
Accumulated Depreciation
Investment in Special Foods Stock
300,000
Total Assets
$1,100,000
$500,000
$
100,000
$100,000
Bonds Payable
200,000
100,000
Common Stock
500,000
200,000
Retained Earnings
300,000
100,000
$1,100,000
$500,000
Liabilities & Stockholders’ Equity
Accounts Payable
Total Liabilities & Equity
In this example, Peerless’s investment is exactly equal to the book value of equity of Special Foods. Therefore, no goodwill is recorded and all assets and
liabilities are simply combined from Special Foods’ financial statements at their current book values. In Chapters 4 and 5, we will explore situations in which
the acquiring company pays more than the book value of the acquired company’s net assets (i.e., when there is a positive differential). However, in Chapters
2 and 3, the excess value of identifiable net assets and goodwill will always be equal to zero. To maintain a consistent approach through all four chapters, we
always illustrate the components of the acquiring company’s investment, even though it will always be exactly equal to its share of the book value of net
assets in Chapters 2 and 3. Therefore, the relationship between the fair value of the consideration given to acquire Special Foods, the fair value of Special
Foods’ net assets, and the book value of Special Foods’ net assets can be illustrated as follows:
The book value of Special Foods’ equity as of the acquisition date is equal to the sum of common stock and retained earnings:
Book Value Calculations:
Total Investment
Original Book Value
=
Common Stock
300,000
+
Retained Earnings
200,000
100,000
Therefore, the consolidation entry simply credits the Investment in Special Foods Stock account (for the acquisition price, $300,000) from Peerless’s
balance sheet. In this and all future examples, we use blue highlighting with white drop-out lettering to designate the numbers from the book
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value analysis that appear in the basic consolidation entry:
Investment in Special Foods
Acquisition
Price
300,000
300,000
Basic consolidation entry
0
The corresponding debits eliminate the beginning balances in the equity accounts of Special Foods:
Basic Consolidation Entry:
Common Stock
200,000
←
Common stock balance
Retained Earnings
100,000
←
Beginning balance in ret. earnings
←
Book value in investment account
Investment in Special Foods
300,000
Remember that this entry is made in the consolidation worksheet, not on the books of either the parent or the subsidiary, and is presented here in general
journal form only for instructional purposes.
The investment account must be eliminated because, from a single entity viewpoint, a company cannot hold an investment in itself. The subsidiary’s
stockholders’ equity accounts must be eliminated because the subsidiary’s stock is held entirely within the consolidated entity and none represents claims by
outsiders.
From a somewhat different viewpoint, the investment account on the parent’s books can be thought of as a single account representing the parent’s
investment in the net assets of the subsidiary, a so-called one-line consolidation. In a full consolidation, the subsidiary’s individual assets and liabilities are
combined with those of the parent. Including both the net assets of the subsidiary, as represented by the balance in the investment account, and the
subsidiary’s individual assets and liabilities would double-count the same set of assets. Therefore, the investment account is eliminated and not carried to the
consolidated balance sheet.
In this example, the acquisition price of the stock acquired by Peerless is equal to the fair value of Special Foods as a whole. This assumption reflects the
normal situation in which the acquisition price paid by the parent is equal to the fair value of its proportionate share of the subsidiary. In addition, this example
assumes that the subsidiary’s fair value is equal to its book value, a generally unrealistic assumption. Given this assumption, however, the balance of
Peerless’s investment account is equal to Special Foods’ stockholders’ equity accounts, so this worksheet entry fully eliminates Peerless’s investment
account against Special Foods’ stockholders’ equity accounts.
The Accumulated Depreciation Consolidation Entry
When a company acquires a depreciable asset, it records the asset with a zero balance in accumulated depreciation (i.e., without any accumulated
depreciation previously recorded by the seller). Likewise, when a company acquires all of the net assets of another company, the depreciable assets acquired
are recorded without any existing accumulated depreciation from the seller’s books. The buyer disregards the seller’s historical cost and accumulated since
they are irrelevant to the acquiring company. For the same reason, when a parent company acquires the stock of a subsidiary, the consolidated financial
statements should include the depreciable assets of the subsidiary without the preacquisition accumulated depreciation. However, in a stock acquisition, the
consolidation worksheet begins with the book values reflected in the subsidiary’s financial statements. Eliminating the old accumulated depreciation of the
subsidiary as of the acquisition date and netting it out against the historical cost gives the appearance that the depreciable assets have been newly page 63
acquired as of the acquisition date. Special Foods’ books indicate accumulated depreciation on the acquisition date of $300,000. Thus, the
following consolidation entry will be made to eliminate this acquisition date subsidiary accumulated depreciation:
Accumulated Depreciation Consolidation Entry:
Accumulated Depreciation
Buildings & Equipment
300,000
Accumulated depreciation at the
← time of the acquisition netted
300,000
against cost
Note that this worksheet consolidation entry does not change the net buildings and equipment balance. Netting the preacquisition accumulated
depreciation against the cost basis of the corresponding assets merely causes the buildings and equipment to appear in the consolidated financial statements
as if they had been acquired without their existing accumulated depreciation.
As explained previously, consolidation entries are not made on the books of any company, so they do not carry over from period to period. Thus, we
would make this same accumulated depreciation consolidation entry each succeeding period as long as these depreciable assets remain on Special Foods’
books (always based on the accumulated depreciation balance as of the acquisition date).
Consolidation Worksheet
We present the worksheet for the preparation of a consolidated balance sheet immediately following the acquisition in Figure 2–7. The first two columns of
the worksheet in Figure 2–7 are the account balances taken from the books of Peerless and Special Foods, as shown in Figure 2–6. The balances of like
accounts are placed side by side so that they may be added together. If more than two companies were to be consolidated, a separate column would be
included in the worksheet for each additional subsidiary.
F I G U R E 2 –7
Worksheet for Consolidated Balance Sheet, January 1, 20X1, Date of Combination; 100 Percent Acquisition at Book Value
The accounts are placed in the worksheet in the order they would normally appear in the companies’ financial statements. The two columns labeled
Consolidation Entries in Figure 2–7 are used to adjust the amounts reported by the individual companies to the amounts appropriate for the consolidated
statement. All adjustments made in the worksheets are made in double-entry form. Thus, when the worksheet is completed, total debits entered in the Debit
Consolidation column must equal total credits entered in the Credit Consolidation column. We highlight all parts of each consolidation entry
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with the same color so that the reader can identify the individual consolidation entries in the worksheet. After the appropriate consolidation
entries have been entered in the Consolidation Entries columns, summing algebraically across the individual accounts provides the consolidated totals.
F I G U R E 2 –8
Consolidated Balance Sheet, January 1, 20X1, Date of Combination; 100 Percent Acquisition at Book Value
The consolidated balance sheet presented in Figure 2–8 comes directly from the last column of the consolidation worksheet in Figure 2–7. Because no
operations occurred between the date of combination and the preparation of the consolidated balance sheet, the stockholders’ equity section of the
consolidated balance sheet is identical to that of Peerless in Figure 2–6.
CONSOLIDATION SUBSEQUENT TO ACQUISITION
The preceding section introduced the procedures used to prepare a consolidated balance sheet as of the acquisition date. However, more than a consolidated
balance sheet is needed to provide a comprehensive picture of the consolidated entity’s activities following acquisition. As with a single company, the set of
basic financial statements for a consolidated entity consists of a balance sheet, an income statement, a statement of changes in retained earnings, and a
statement of cash flows.
This section of the chapter presents the procedures used to prepare an income statement, statement of retained earnings, and consolidated balance sheet
subsequent to the acquisition date. We discuss the preparation of a consolidated statement of cash flows in Chapter 10.
The following discussion first deals with the important concepts of consolidated net income and consolidated retained earnings, followed by a description
of the worksheet format used to facilitate the preparation of a full set of consolidated financial statements. We then discuss the specific procedures used to
prepare consolidated financial statements subsequent to the date of combination.
This and subsequent chapters focus on procedures for consolidation when the parent company accounts for its investment in subsidiary stock using the
equity method. If the parent accounts for its investment using the cost method, the general approach to the preparation of consolidated financial statements is
the same, but the specific consolidation entries differ. Appendix 2B summarizes consolidation procedures using the cost method. Regardless of the method
the parent uses to account for its subsidiary investment, the consolidated statements will be the same because the investment and related accounts are
eliminated in the consolidation process.
The approach followed to prepare a complete set of consolidated financial statements subsequent to a business combination is quite similar to that used to
prepare a consolidated balance sheet as of the date of combination. However, in addition to the assets and liabilities, the consolidating companies’ revenues
and expenses must be combined. As the accounts are combined, adjustments must be made in the consolidation worksheet so that the
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consolidated financial statements appear as if they are the financial statements of a single company.
When a full set of consolidated financial statements is prepared subsequent to the date of combination, two of the important concepts affecting the
statements are those of consolidated net income and consolidated retained earnings.
Consolidated Net Income
All revenues and expenses of the individual consolidating companies arising from transactions with unaffiliated companies are included in the consolidated
financial statements. The consolidated income statement includes 100 percent of the revenues and expenses regardless of the parent’s percentage ownership.
Similar to single-company financial statements, where the difference between revenues and expenses equals net income, revenues minus expenses in the
consolidated financial statements equal consolidated net income. Consolidated net income is equal to the parent’s income from its own operations, excluding
any investment income from consolidated subsidiaries, plus the net income from each of the consolidated subsidiaries, adjusted for any differential write-off
(which is zero in this chapter). Intercorporate investment income from consolidated subsidiaries included in the parent’s net income under either the cost or
the equity method must be eliminated in computing consolidated net income to avoid double-counting.
Consolidated net income and consolidated net income attributable to the controlling interest are the same when all consolidated subsidiaries are wholly
owned. For example, assume that Push Corporation purchases all of the stock of Shove Company at an amount equal to its book value. During 20X1, Shove
reports net income of $25,000 while Push reports net income of $125,000, including equity-method income from Shove of $25,000. Consolidated net
income for 20X1 is computed as follows:
Push’s net income
$125,000
Less: Equity-method income from Shove
Shove’s net income
(25,000)
25,000
Consolidated net income
$125,000
Note that when the parent company properly applies the equity method, consolidated net income is always equal to the parent’s equity-method net income.
Consolidated Retained Earnings
Consolidated retained earnings, as it appears in the consolidated balance sheet, is that portion of the consolidated enterprise’s undistributed earnings
accruing to the parent company shareholders. Consolidated retained earnings at the end of the period is equal to the beginning consolidated retained earnings
balance, plus consolidated net income attributable to the controlling interest, less dividends declared by the parent company.
Computing Consolidated Retained Earnings
Consolidated retained earnings is computed by adding together the parent’s retained earnings from its own operations (excluding any income from
consolidated subsidiaries recognized by the parent) and the parent’s proportionate share of the net income of each subsidiary since the date of acquisition,
adjusted for differential write-off and goodwill impairment. Consolidated retained earnings should be equal to the parent’s equity-method retained earnings.
If the parent accounts for subsidiaries using the equity method on its books, the retained earnings of each subsidiary is completely eliminated when the
subsidiary is consolidated. This is necessary because (1) retained earnings cannot be purchased, and so subsidiary retained earnings at the date of a business
combination cannot be included in the combined company’s retained earnings; (2) the parent’s share of the subsidiary’s income since acquisition is already
included in the parent’s equity-method retained earnings; and (3) the noncontrolling interest’s share (if any) of the subsidiary’s retained
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earnings is not included in consolidated retained earnings.
In the simple example given previously, assume that on the date of combination, January 1, 20X1, Push’s retained earnings balance is $400,000 and
Shove’s is $250,000. During 20X1, Shove reports $25,000 of net income and declares $10,000 of dividends. Push reports $100,000 of separate operating
earnings plus $25,000 of equity-method income from its 100 percent interest in Shove; Push declares dividends of $30,000. Based on this information, the
retained earnings balances for Push and Shove on December 31, 20X1, are computed as follows:
Push
Shove
$400,000
$250,000
Net income, 20X1
125,000
25,000
Dividends declared in 20X1
(30,000)
(10,000)
Balance, January 1, 20X1
Balance, December 31, 20X1 $495,000
$265,000
Consolidated retained earnings is computed by first determining the parent’s retained earnings from its own operations. This computation involves
removing from the parent’s retained earnings the $25,000 of subsidiary income since acquisition recognized by the parent, leaving $470,000 ($495,000 −
$25,000) of retained earnings resulting from the parent’s own operations. The parent’s 100 percent share of the subsidiary’s net income since the date of
acquisition is then added to this number, resulting in consolidated retained earnings of $495,000. We note that because this is the first year since the
acquisition, the net income since the date of acquisition is just this year’s income. Subsequent examples will illustrate how this calculation differs in later
years. We also emphasize that since Push uses the fully adjusted equity method, this number is the same as the parent’s equity-method retained earnings.
CONSOLIDATED FINANCIAL STATEMENTS—100 PERCENT OWNERSHIP, CREATED OR
ACQUIRED AT BOOK VALUE
Each of the consolidated financial statements is prepared as if it is taken from a single set of books that is being used to account for the overall consolidated
entity. There is, of course, no set of books for the consolidated entity, and as in the preparation of the consolidated balance sheet, the consolidation process
starts with the data recorded on the books of the individual consolidating companies. The account balances from the books of the individual companies are
placed in the three-part worksheet, and entries are made to eliminate the effects of intercorporate ownership and transactions. The consolidation approach
and procedures are the same whether the subsidiary being consolidated was acquired or created.
To understand the process of consolidation subsequent to the start of a parent-subsidiary relationship, assume that on January 1, 20X1, Peerless Products
Corporation acquires all of the common stock of Special Foods Inc. for $300,000, an amount equal to Special Foods’ book value on that date. At that time,
Special Foods has $200,000 of common stock outstanding and retained earnings of $100,000, summarized as follows:
Peerless accounts for its investment in Special Foods stock using the equity method. Information about Peerless and Special Foods as of the date of
combination and for the years 20X1 and 20X2 appears in Figure 2–9.
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FIGURE 2–9
Selected Information about Peerless Products and Special Foods on January 1, 20X1,
and for the Years 20X1 and 20X2
Peerless
Products
Common Stock, January 1, 20X1
Retained Earnings, January 1, 20X1
Special
Foods
$500,000
$200,000
300,000
100,000
20X1:
Separate Operating Income, Peerless
140,000
Net Income, Special Foods
Dividends
50,000
60,000
30,000
20X2:
Separate Operating Income, Peerless
160,000
Net Income, Special Foods
Dividends
75,000
60,000
40,000
Initial Year of Ownership
On January 1, 20X1, Peerless records its purchase of Special Foods common stock with the following entry:
(8)
Investment in Special Foods
300,000
Cash
300,000
Record the purchase of Special Foods stock.
During 20X1, Peerless records operating earnings of $140,000, excluding its income from investing in Special Foods, and declares dividends of $60,000.
Special Foods reports 20X1 net income of $50,000 and declares dividends of $30,000.
Parent Company Entries
Peerless records its 20X1 income and dividends from Special Foods under the equity method as follows:
(9)
Investment in Special Foods
Income from Special Foods
Record Peerless’s 100% share of Special Foods’ 20X1 income.
50,000
50,000
(10)
Cash
Investment in Special Foods
30,000
30,000
Record Peerless’s 100% share of Special Foods’ 20X1 dividend.
Consolidation Worksheet—Initial Year of Ownership
After all appropriate entries have been made on the books of Peerless and Special Foods, including year-end adjustments, a consolidation worksheet is
prepared as in Figure 2–10. The adjusted account balances from the books of Peerless and Special Foods are placed in the first two columns of the
worksheet. Then all amounts that reflect intercorporate transactions or ownership are eliminated in the consolidation process.
The distinction between journal entries recorded on the books of the individual companies and the consolidation entries recorded only on the consolidation
worksheet is an important one. Book entries affect balances on the books and the amounts that are carried to the consolidation worksheet; worksheet
consolidation entries affect only those balances carried to the consolidated financial statements in that period. As mentioned previously, the consolidation
entries presented in this text are shaded both when presented in journal entry form in the text and in the worksheet.
In this example, the accounts that must be eliminated because of intercorporate ownership are the stockholders’ equity accounts of Special Foods
(including dividends declared), Peerless’s investment in Special Foods stock, and Peerless’s income from Special Foods. However, unlike previous examples,
the book value portion of Peerless’s investment has changed because earnings and dividends have adjusted the investment account balance.
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The book value portion of the investment account can be summarized as follows:
F I G U R E 2 –1 0
December 31, 20X1, Equity-Method Worksheet for Consolidated Financial Statements, Initial Year of Ownership; 100 Percent
Acquisition at Book Value
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Under the equity method, Peerless recognizes its share (100 percent) of Special Foods’ reported income. In the consolidated income statement, however,
Special Foods’ individual revenue and expense accounts are combined with Peerless’s accounts. Peerless’s equity method income from Special Foods,
therefore, must be eliminated to avoid double-counting. Special Foods’ dividends paid to Peerless must be eliminated when consolidated statements are
prepared (because the dividend is really just an intercompany cash transfer, not a transfer of wealth to external shareholders) so that only dividend
declarations related to the parent’s shareholders are reported as dividends of the consolidated entity. Thus, the basic consolidation entry removes both the
equity method Income from Special Foods and also all dividends declared by Special Foods during the period:
Basic Consolidation Entry:
Common Stock
200,000
← Common stock balance
Retained Earnings
100,000
← Beginning balance in ret. earnings
Income from Special Foods
Dividends Declared
Investment in Special Foods
50,000
← Special Foods’ reported income
30,000
320,000
← 100% of Special Foods’ dividends
← Net BV in investment account
The book value calculations in the chart on the previous page help to facilitate preparation of the basic consolidation entry. Thus, the basic consolidation
entry removes (1) Special Foods’ equity accounts, (2) Special Foods’ dividends declared, (3) Peerless’s Income from Special Foods account, and (4)
Peerless’s Investment in Special Foods account. Note that we use blue highlighting with white drop-out numbers in the book value analysis that appear in the
basic consolidation entry. Also note that we eliminate the beginning retained earnings balance since income and dividends are eliminated separately. Because
there is no differential in this example, the basic consolidation entry completely eliminates the balance in Peerless’s investment account on the balance sheet
as well as the Income from Special Foods account on the income statement in the worksheet. Additional consolidation entries will be necessary when there is
a differential as illustrated in Chapters 4 and 5.
We show the worksheet entry in these T-accounts only to illustrate how these accounts are eliminated in the consolidation worksheet. Consolidation
entries do not affect the actual books of either the parent or the subsidiary.
As explained previously, we repeat the accumulated depreciation worksheet entry in each succeeding period for as long as the subsidiary owns these
assets. The purpose of this entry is to appropriately present these assets in the consolidated financial statements as if they had been purchased on the date the
subsidiary was acquired at their acquisition date book values with no preacquisition accumulated depreciation.
Accumulated Depreciation Consolidation Entry:
Accumulated Depreciation
300,000
Buildings & Equipment
300,000
Accumulated depreciation at the
← time of the acquisition netted
against cost
page 70
Worksheet Relationships
Both of the consolidation entries are entered in Figure 2–10 and the amounts are totaled across each row and down each column to complete the worksheet.
Some specific points to recognize with respect to the full worksheet are as follows:
1. Because of the normal articulation among the financial statements, the bottom-line number from each of the first two sections of the worksheet carries down to the
next financial statement in a logical progression. As part of the normal accounting cycle, net income is closed to retained earnings, and retained earnings is
reflected in the balance sheet. Therefore, in the consolidation worksheet, the net income is carried down to the retained earnings statement section of the
worksheet, and the ending retained earnings line is carried down to the balance sheet section of the worksheet. Note that in both cases the entire line, including
total adjustments, is carried forward.
2. Double-entry bookkeeping requires total debits to equal total credits for any single consolidation entry and for the worksheet as a whole. Because some
consolidation entries extend to more than one section of the worksheet, however, the totals of the debit and credit adjustments are not likely to be equal in either of
the first two sections of the worksheet. The totals of all debits and credits at the bottom of the balance sheet section are equal because the cumulative balances
from the two upper sections are carried forward to the balance sheet section.
3. In the balance sheet portion of the worksheet, total debit balances must equal total credit balances for each company and for the consolidated entity.
4. When the parent uses the full equity method of accounting for the investment, consolidated net income should equal the parent’s net income, and consolidated
retained earnings should equal the parent’s retained earnings. This means the existing balance in subsidiary retained earnings must be eliminated to avoid doublecounting.
5. Certain other clerical safeguards are incorporated into the worksheet. The amounts reflected in the bottom line of the income statement section, when summed
(algebraically) across, must equal the number reported as consolidated net income. Similarly, the amounts in the last line of the retained earnings statement section
must equal consolidated retained earnings when summed across.
Second and Subsequent Years of Ownership
The consolidation procedures employed at the end of the second and subsequent years are basically the same as those used at the end of the first year.
Adjusted trial balance data of the individual companies are used as the starting point each time consolidated statements are prepared because no separate
books are kept for the consolidated entity. An additional check is needed in each period following acquisition to ensure that the beginning balance of
consolidated retained earnings shown in the completed worksheet after consolidation entries equals the balance reported at the end of the prior period. In all
other respects, the consolidation entries and worksheet are comparable with those shown for the first year.
Parent Company Entries
We illustrate consolidation after two years of ownership by continuing the example of Peerless Products and Special Foods, based on the data in Figure 2–9.
Peerless’s separate income from its own operations for 20X2 is $160,000, and its dividends total $60,000. Special Foods reports net income of $75,000 in
20X2 and pays dividends of $40,000. Peerless records the following equity-method entries in 20X2:
(11)
Investment in Special Foods
75,000
Income from Special Foods
75,000
Record Peerless’s 100% share of Special Foods’ 20X2 income.
(12)
Cash
Investment in Special Foods
Record Peerless’s 100% share of Special Foods’ 20X2 dividend.
40,000
40,000
page 71
The balance in the investment account reported by Peerless increases from $320,000 on January 1, 20X2, to $355,000 on December 31, 20X2, and
reported net income of Peerless totals $235,000 ($160,000 + $75,000).
Consolidation Worksheet—Second Year of Ownership
Figure 2–11 illustrates the worksheet to prepare consolidated statements for 20X2. The book value of Peerless’s investment in Special Foods (which is equal
to the book value of Special Foods’ equity accounts) can be analyzed and summarized as follows:
Again, the basic consolidation entry removes (1) Special Foods’ equity accounts, (2) Special Foods’ dividends declared, (3) Peerless’s Income from
Special Foods account, and (4) Peerless’s Investment in Special Foods account:
Basic Consolidation Entry:
Common Stock
200,000
← Common stock balance
Retained Earnings
120,000
← Beginning balance in RE
Income from Special Foods
Dividends Declared
Investment in Special Foods
75,000
← Special Foods’ reported income
40,000
355,000
← 100% of Special Foods’ dividends
← Net BV in investment account
Note that the beginning balance in retained earnings in 20X2, $75,000, is different than the balance in 20X1 because of income earned and dividends
declared during 20X1. However, it is the beginning balance in retained earnings that is eliminated since income and dividends are eliminated separately. As
explained previously, since there is no differential in this example, the basic consolidation entry completely eliminates the balance in Peerless’s investment
account on the balance sheet as well as the Income from Special Foods account on the income statement in the worksheet.
page 72
We again show the worksheet entry in these T-accounts only to illustrate how these accounts are eliminated in the consolidation worksheet. Consolidation
entries do not affect the actual books of either the parent or the subsidiary.
In this example, Special Foods had accumulated depreciation of $300,000 on the acquisition date. Thus, we repeat the same accumulated depreciation
consolidation entry this year (and every year as long as Special Foods owns the assets) that we used in the initial year.
Accumulated Depreciation Consolidation Entry:
Accumulated Depreciation
Buildings & Equipment
300,000
300,000
Accumulated depreciation at the
← time of the acquisition netted
against cost
After placing the two consolidation entries in the consolidation worksheet, it is completed in the normal manner as illustrated in Figure 2–11. All
worksheet relationships discussed in conjunction with Figure 2–10 continue in the second year as well. The beginning consolidated retained earnings balance
for 20X2, as shown in Figure 2–11, should be compared with the ending consolidated retained earnings balance for 20X1, as shown in Figure 2–10, to
ensure that they are the same.
F I G U R E 2 –1 1
December 31, 20X2, Equity-Method Worksheet for Consolidated Financial Statements, Second Year of Ownership; 100 Percent
Acquisition at Book Value
page 73
Consolidated Net Income and Retained Earnings
In the consolidation worksheets illustrated in Figures 2–10 and 2–11, consolidated net income for 20X1 and 20X2 appear as the last numbers in the income
statement section of the worksheets in the Consolidated column on the far right. The numbers can be computed as follows:
Peerless’s net income
Peerless’s equity income from Special Foods
Special Foods’ net income
Consolidated net income
20X1
20X2
$190,000
$235,000
(50,000)
(75,000)
50,000
75,000
$190,000
$235,000
In this simple illustration, consolidated net income is the same as Peerless’s equity-method net income.
In Figures 2–10 and 2–11, the ending consolidated retained earnings number is equal to the beginning balance of consolidated retained earnings plus
consolidated net income, less dividends declared on the parent’s common stock. It also can be computed as follows:
Peerless’s beginning retained earnings from its own operations
Peerless’s income from its own operations
Peerless’s income from Special Foods since acquisition (cumulative)
Peerless’s dividends declared
Consolidated retained earnings
20X1
20X2
$300,000
$380,000
140,000
160,000
50,000
125,000
(60,000)
(60,000)
$430,000
$605,000
As with income, consolidated retained earnings is the same as the parent’s equity-method retained earnings if the parent company uses the equity method.
We note that the second year of this calculation illustrates how cumulative income from Special Foods (since the acquisition date) can be used to calculate
ending retained earnings.
STOP & THINK
Note that Peerless’s beginning retained earnings from its own operations in 20X2, $380,000, is calculated
as the beginning balance for 20X1 plus Peerless’s income from its own operations in 20X1, $140,000, minus
its dividends declared in 20X1, $60,000.
SUMMARY OF KEY CONCEPTS
Companies owning investments in the common stock of other companies generally report those investments by consolidating them, or carrying them at fair value,
or they account for them using the equity method, depending on the circumstances. Consolidation generally is appropriate if one entity controls the investee,
usually through majority ownership of the investee’s voting stock. The equity method is required when an investor has sufficient stock ownership in an investee to
significantly influence the operating and financial policies of the investee but owns less than a majority of the investee’s stock. In the absence of other evidence,
ownership of 20 percent or more of an investee’s voting stock is viewed as giving the investor the ability to exercise significant influence over the investee.
Investments are usually carried at fair value when consolidation and the equity method are not appropriate, usually when the investor is unable to exercise
significant influence over the investee.
The equity method is unique in that the carrying value of the investment is adjusted periodically to reflect the investor’s changing equity in the underlying
investee. Income from the investment is recognized by the investor under the equity method as the investee reports the income rather than when it is distributed.
page 74
Companies typically carry investments at fair value when the equity method or consolidation is not appropriate. These investments are remeasured to fair value
at the end of each reporting period and the change in value is recognized as an unrealized gain or loss in income. Consistent with the realization concept, income
from the investment is recognized when declared by the investee in the form of dividends.
Consolidated financial statements present the financial position and results of operations of two or more separate legal entities as if they were a single company.
A consolidated balance sheet prepared on the date a parent acquires a subsidiary appears the same as if the acquired company had been merged into the parent.
A consolidation worksheet provides a means of efficiently developing the data needed to prepare consolidated financial statements. The worksheet includes a
separate column for the trial balance data of each of the consolidating companies, a debit and a credit column for the consolidation entries, and a column for the
consolidated totals that appear in the consolidated financial statements. A three-part consolidation worksheet facilitates preparation of a consolidated income
statement, retained earnings statement, and balance sheet, and it includes a section for each statement. Consolidation entries are needed in the worksheet to remove
the effects of intercompany ownership and intercompany transactions so the consolidated financial statements appear as if the separate companies are actually one.
KEY TERMS
affiliate, 59
carried at fair value, 48
consolidated net income, 65
consolidated retained earnings, 65
consolidation, 49
consolidation entries, 59
consolidation worksheet, 57
control, 49
corporate joint venture, 51
equity accrual, 52
equity method, 48
fully adjusted equity method, 66
modified equity method, 77
one-line consolidation, 56
parent, 49
significant influence, 48
subsidiary, 49
unconsolidated subsidiary, 49
Appendix 2A
Additional Considerations Relating to
the Equity Method
DETERMINATION OF SIGNIFICANT INFLUENCE
The general rule established in ASC 323 is that the equity method is appropriate when the investor, by virtue of its common stock interest in an investee, is able to
exercise significant influence, but not control, over the operating and financial policies of the investee. In the absence of other evidence, common stock ownership
of 20 percent or more is viewed as indicating that the investor is able to exercise significant influence over the investee. However, ASC 323-10-15-6 also states a
number of factors that could constitute other evidence of the ability to exercise significant influence:
1. Representation on board of directors.
2. Participation in policy making.
3. Material intercompany transactions.
4. Interchange of managerial personnel.
5. Technological dependency.
6. Size of investment in relation to concentration of other shareholdings.
Conversely, the FASB provides in ASC 323-10-15-10 some examples of evidence where an investor is unable to exercise significant influence over an investee.
These situations include legal or regulatory challenges to the investor’s influence by the investee, agreement by the investor to give up important shareholder
rights, concentration of majority ownership among a small group of owners who disregard the views of the investor, and unsuccessful attempts by the investor to
obtain information from the investee or to obtain representation on the investee’s board of directors.
page 75
UNREALIZED INTERCOMPANY PROFITS
Only “arms-length” transactions (i.e., those conducted between completely independent parties who act in their own best interests) may be reflected in the
consolidated financial statements. Thus, all aspects of intercompany transfers must be eliminated in preparing consolidated financial statements so that the
statements appear as if they were those of a single company.
ADJUSTING FOR UNREALIZED INTERCOMPANY PROFITS
An intercompany sale normally is recorded on the books of the selling affiliate in the same manner as any other sale, including the recognition of profit. In applying
the equity method, any intercompany profit remaining unrealized at the end of the period must be deducted from the amount of income that otherwise would be
reported.
The income recognized from the investment and the carrying amount of the investment are reduced to remove the effects of the unrealized intercompany profits.
In future periods when the intercompany profit actually is realized, the entry is reversed.
UNREALIZED PROFIT ADJUSTMENTS ILLUSTRATED
To illustrate the adjustment for unrealized intercompany profits under the equity method, assume that Palit Corporation owns 40 percent of the common stock of
Label Manufacturing. During 20X1, Palit sells inventory to Label for $10,000; the inventory originally cost Palit $7,000. Label resells one-third of the inventory to
outsiders during 20X1 and retains the other two-thirds in its ending inventory. The amount of unrealized profit is computed as follows:
Total intercompany profit $10,000 − $7,000 = $3,000
Unrealized portion
$3,000 × 2/3 = $2,000
Assuming that Label reports net income of $60,000 for 20X1 and declares no dividends, the following entries are recorded on Palit’s books at the end of 20X1:
(13)
Investment in Label Manufacturing
24,000
Income from Label Manufacturing
24,000
Record equity-method income: $60,000 × 0.40.
(14)
Income from Label Manufacturing
2,000
Investment in Label Manufacturing
2,000
Remove unrealized intercompany profit.
If all the remaining inventory is sold in 20X2, the following entry is made on Palit’s books at the end of 20X2 to record the realization of the previously unrealized
intercompany profit:
(15)
Investment in Label Manufacturing Stock
2,000
Income from Label Manufacturing
2,000
Recognize realized intercompany profit.
ADDITIONAL REQUIREMENTS OF ASC 323-10
ASC 323-10, the main authoritative guidance on equity-method reporting, includes several additional requirements:
1. The investor’s share of the investee’s income from discontinued operations and prior-period adjustments should be reported as such by the investor, if
material.
2. If an investor’s share of investee losses exceeds the carrying amount of the investment, the equity method should be discontinued once the investment has
been reduced to zero. No further losses are to be recognized by the investor unless the investor is committed to provide further financial support for the
investee or unless the investee’s imminent return to profitability appears assured. If after the equity method has been suspended the investee reports page 76
net income, the investor again should apply the equity method, but only after the investor’s share of net income equals its share of losses not
previously recognized.
3. Preferred dividends of the investee should be deducted from the investee’s net income if declared or, whether declared or not, if the preferred stock is
cumulative, before the investor computes its share of investee earnings.
ASC 323-10-50-3 includes a number of required financial statement disclosures. When using the equity method, the investor must disclose the following:
1. The name and percentage ownership of each investee.
2. The accounting policies of the investor with respect to investments in common stock. Disclosure shall include the names of any significant investee entities in
which the investor holds 20 percent or more of the voting stock, but the common stock is not accounted for on the equity method, together with the reasons
why the equity method is not considered appropriate, and the names of any significant investee corporations in which the investor holds less than 20 percent
of the voting stock and the common stock is accounted for on the equity method, together with the reasons why the equity method is considered appropriate.
3. The difference, if any, between the amount at which an investment is carried and the amount of underlying equity in net assets and the accounting treatment of
the difference.
4. The aggregate market value of each identified nonsubsidiary investment where a quoted market price is available.
5. Either separate statements for or summarized information as to assets, liabilities, and results of operations of corporate joint ventures of the investor, if material
in the aggregate.
6. Material effects of possible conversions, exercises, or contingent issuances.
INVESTOR’S SHARE OF OTHER COMPREHENSIVE INCOME
When an investor uses the equity method to account for its investment in another company, the investor’s comprehensive income should include its proportionate
share of each of the amounts reported as “Other Comprehensive Income” by the investee. For example, assume that Ajax Corporation purchases 40 percent of the
common stock of Barclay Company on January 1, 20X1. For the year 20X1, Barclay reports net income of $80,000 and comprehensive income of $115,000, which
includes other comprehensive income (in addition to net income) of $35,000. In addition to recording the normal equity-method entries, Ajax recognizes its
proportionate share of the other comprehensive income reported by Barclay during 20X1 with the following entry:
(16) Investment in Barclay Stock
14,000
Income reported by investee in OCI
14,000
Recognize investor’s share of Other Comprehensive Income reported by investee ($35,000 × 0.40).
Entry (16) has no effect on Ajax’s net income for 20X1, but it does increase Ajax’s other comprehensive income, and thus its total comprehensive income, by
$14,000. Ajax will make a similar entry at the end of each period for its proportionate share of any increase or decrease in Barclay’s accumulated other comprehensive
income.
ALTERNATIVE VERSIONS OF THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS IN
CONSOLIDATED SUBSIDIARIES
Companies are free to adopt whatever procedures they wish in accounting for investments in controlled subsidiaries on their books. Because investments in
consolidated subsidiaries are eliminated when consolidated statements are prepared, the consolidated statements are not affected by the procedures used to
account for the investments on the parent’s books.
page 77
In practice, companies follow three different approaches in accounting for their consolidated subsidiaries:
1. Carry investments at cost.
2. Use fully adjusted equity method.
3. Apply modified version of the equity method.
Several modified versions of the equity method are found in practice, and all are usually referred to as the modified equity method. Some companies apply the
equity method without making adjustments for unrealized intercompany profits and the amortization of the differential. Others adjust for the amortization of the
differential but omit the adjustments for unrealized intercompany profits. Modified versions of the equity method may provide some clerical savings for the parent if
used on the books when consolidation of the subsidiary is required.
Appendix 2B
Consolidation When Parent Companies
Choose to Carry at Cost Investments
That Are To Be Consolidated
Not all parent companies use the equity method to account for their subsidiary investments that are to be consolidated. As an alternative, some parent companies
choose to carry at historical cost those investments that are to be consolidated. The choice of historical cost or the equity method has no effect on the consolidated
financial statements. This is true because the balance in the parent’s investment account, the parent’s income from the subsidiary, and related items are eliminated in
preparing the consolidated statements. Thus, the parent is free to use either the historical cost or some version of the equity method on its separate books in
accounting for investments in subsidiaries that are to be consolidated.
Because the cost method uses different parent company entries than the equity method, it also requires different consolidation entries in preparing the
consolidation worksheet. Keep in mind that the consolidated financial statements appear the same regardless of whether the parent uses the cost or the equity
method on its separate books.
CONSOLIDATION—YEAR OF COMBINATION
To illustrate the preparation of consolidated financial statements when the parent company carries its subsidiary investment at historical cost, refer again to the
Peerless Products and Special Foods example. Assume that Peerless purchases 100 percent of the common stock of Special Foods on January 1, 20X1, for $300,000.
At that date, the book value of Special Foods as a whole is $300,000. All other data are the same as presented in Figures 2–5 and 2–6.
Parent Company Entries When Investments Are Carried at Cost
Peerless elects to carry the investment in Special Foods at cost because Peerless plans to consolidate this investment. Peerless records only two journal entries
during 20X1 related to its investment in Special Foods. Entry (17) records Peerless’s purchase of Special Foods stock; entry (18) recognizes dividend income based
on the $30,000 ($30,000 × 100%) of dividends received during the period:
(17)
Investment in Special Foods
300,000
Cash
300,000
Record the initial investment in Special Foods.
(18)
Cash
30,000
Dividend Income
30,000
Record Peerless’s 100% share of Special Foods’ 20X1 dividend.
No entries are made on the parent’s books with respect to Special Foods income in 20X1, as would be done under the equity method.
Consolidation Worksheet—Year of Combination
Figure 2–12 illustrates the worksheet to prepare consolidated financial statements for December 31, 20X1, with investments carried at cost. The trial balance data for
Peerless and Special Foods included in the worksheet in Figure 2–12 differ from those presented in Figure 2–10 only by the effects of carrying the page 78
investment at cost rather than using the equity method on Peerless’s books. Note that all of the amounts in the Consolidated column are the same as in
Figure 2–10 because the method used by the parent to account for its subsidiary investment on its books has no effect on the consolidated financial statements.
F I G U R E 2 –1 2
December 31, 20X1, Worksheet for Consolidated Financial Statements, Initial Year of Ownership; 100 Percent Acquisition at Book
Value and Investments Are Carried at Cost
When a company carries investments at cost, the basic consolidation entry can be divided into two parts. The first eliminates the investment account. The
investment consolidation entry eliminates the balances in the stockholders’ equity accounts of Special Foods and the balance in Peerless’s investment account as
of the date of combination. This consolidation entry is the same each year (assuming there is no impairment of the investment account) because it relates to the
original acquisition price and the original balances in Special Foods’ equity accounts.
Investment Consolidation Entry:
Common Stock
200,000
Retained Earnings
100,000
Investment in Special Foods
300,000
The dividend consolidation entry eliminates the dividend income recorded by Peerless during the period along with Special Foods’ dividend declaration related
to the stockholdings of Peerless.
Dividend Consolidation Entry:
Dividend Income
30,000
Dividends Declared
30,000
page 79
Finally, the accumulated depreciation consolidation entry is the same as under the equity method.
Accumulated Depreciation Consolidation Entry:
Accumulated Depreciation
300,000
Buildings & Equipment
300,000
As mentioned previously, the amounts in the Consolidated column of the worksheet in Figure 2–12 are the same as those in Figure 2–10 because the method
used on the parent’s books to account for the subsidiary investment does not affect the consolidated financial statements.
CONSOLIDATION—SECOND YEAR OF OWNERSHIP
Consolidation differences between carrying investments at cost and using equity-method accounting tend to be more evident in the second year of ownership
simply because the equity-method entries change every year while the cost entries are generally the same (with the exception of recording the initial investment).
Parent Company Entry When Investment Is Carried at Cost
Peerless only records a single entry on its books in 20X2 related to its investment in Special Foods:
(19)
Cash
40,000
Dividend Income
40,000
Record Peerless’s 100% share of Special Foods’ 20X2 dividend.
Consolidation Worksheet—Second Year Following Combination
The worksheet consolidation entries are identical to those used in the first year except that the amount of dividends declared by Special Foods in the second year is
$40,000 instead of $30,000.
Investment Consolidation Entry:
Common Stock
200,000
Retained Earnings
100,000
Investment in Special Foods
300,000
Dividend Consolidation Entry:
Dividend Income
40,000
Dividends Declared
40,000
Accumulated Depreciation Consolidation Entry:
Accumulated Depreciation
Buildings & Equipment
300,000
300,000
When carrying investments at cost, Peerless has not recognized any portion of the undistributed earnings of Special Foods on its parent company books.
Therefore, Peerless’s retained earnings at the beginning of the second year is less than consolidated retained earnings. Also, Peerless’s Investment in Special
Foods account balance is less than its 100 percent share of Special Foods’ net assets at that date. The consolidation worksheet in Figure 2–13 demonstrates how
the worksheet entries eliminate the balances reported by Peerless when carrying the investment at cost.
Note that while the Consolidated column yields identical numbers to those found in Figure 2–11, carrying investments at cost does not maintain the favorable
properties that exist when the equity method is employed. Specifically, the parent’s net income no longer equals consolidated net income, and the parent’s retained
earnings no longer equals the consolidated retained earnings balance. Hence, although the procedures used under the cost method require less work, the parent
company does not enjoy some of the favorable relationships among parent and consolidated numbers that exist under the equity method.
page 80
F I G U R E 2 –1 3
December 31, 20X2, Worksheet for Consolidated Financial Statements, Second Year of Ownership; 100 Percent Acquisition at Book
Value and Investments Are Carried at Cost
QUESTIONS
Q2–1
What types of investments in common stock normally are accounted for using (a) the equity
method and (b) carried at fair value?
LO 2–1
Q2–2
When will the balance in the intercorporate investment account be the same if the investment is
carried at fair value, or if the equity method of accounting is used?
LO 2–4
Q2–3
Describe an investor’s treatment of an investment in common stock that was previously carried
at fair value, if the investment becomes qualified for use of the equity method by an increase in
the level of ownership.
LO 2–2, 2–3
Q2–4
How is the receipt of a dividend recorded under the equity method? When investments are
carried at fair value?
LO 2–2, 2–3
Q2–5
How does carrying securities at fair value differ from the equity method in reporting income
from nonsubsidiary investments?
LO 2–2
Q2–6
Explain the concept of a one-line consolidation.
LO 2–4
Q2–7
How does a consolidation entry differ from an adjusting entry?
LO 2–6
Q2–8
What portion of the balances of subsidiary stockholders’ equity accounts is included in the
consolidated balance sheet?
LO 2–5, 2–6
page 81
Q2–9
How does the consolidation process change when consolidated statements are prepared after—
rather than at—the date of acquisition?
LO 2–6
Q2–10
What are the three parts of the consolidation worksheet, and what sequence is used in
completing the worksheet parts?
LO 2–6
Q2–11
How are a subsidiary’s dividend declarations reported in the consolidated retained earnings
statement?
LO 2–6
Q2–12
How is consolidated net income computed in a consolidation worksheet?
LO 2–6
Q2–13
Give a definition of consolidated retained earnings.
LO 2–6
Q2–14
How is the amount reported as consolidated retained earnings determined?
LO 2–6
Q2–15
Why is the beginning retained earnings balance for each company entered in the three-part
consolidation worksheet rather than just the ending balance?
LO 2–6
Q2–16A
How is the ability to significantly influence the operating and financial policies of a company
normally demonstrated?
LO 2–1
Q2–17A
When is equity-method reporting considered inappropriate even though sufficient common
shares are owned to allow the exercise of significant influence?
LO 2–1
Q2–18A
How does the fully adjusted equity method differ from the modified equity method?
LO 2–3
Q2–19A
What is the modified equity method? When might a company choose to use the modified equity
method rather than the fully adjusted equity method?
LO 2–3
CASES
C2–1
Choice of Accounting Method
LO 2–2, 2–3
Understanding
Slanted Building Supplies purchased 32 percent of the voting shares of Flat Flooring Company in March 20X3. On December 31, 20X3, the officers of Slanted
Building Supplies indicated they needed advice on whether to use the equity method or to carry the investment at fair value in reporting their ownership in Flat
Flooring.
Required
a.
What factors should be considered in determining whether equity-method reporting is appropriate?
b.
Which of the two approaches is likely to show the larger reported contribution to Slanted’s earnings in 20X4? Explain.
c.
Why might the use of the equity method become more appropriate as the percentage of ownership increases?
C2–2
Intercorporate Ownership
LO 2–2, 2–3
Research
Most Company purchased 90 percent of the voting common stock of Port Company on January 1, 20X4, and 15 percent of the voting common stock of Adams
Company on July 1, 20X4. In preparing the financial statements for Most Company at December 31, 20X4, you discover that Port Company purchased 10 percent of
the common stock of Adams Company in 20X2 and continues to hold those shares. Adams Company reported net income of $200,000 for 20X4 and paid a dividend
of $70,000 on December 20, 20X4.
Required
Most Company’s chief accountant instructs you to review the Accounting Standards Codification and prepare a memo discussing whether the equity method
should be used, or alternatively if the investment in Adams Company should be carried at fair value in Most’s consolidated statements prepared at December 31,
20X4. Support your recommendations with citations and quotations from the authoritative financial reporting standards or other literature.
C2–3
Application of the Equity Method
LO 2–2, 2–3
Research
Forth Company owned 85,000 of Brown Company’s 100,000 shares of common stock until January 1, 20X2, at which time it sold 70,000 of the shares to a group of
seven investors, each of whom purchased 10,000 shares. On December 3, 20X2, Forth received a dividend of $9,000 from Brown. Forth continues to page 82
purchase a substantial portion of Brown’s output under a contract that runs until the end of 20X9. Because of this arrangement, Forth is permitted to
place two of its employees on Brown’s board of directors.
Required
Forth Company’s controller is not sure whether the company should use the equity method in accounting for its investment in Brown Company, or if the investment
should be carried at fair value. The controller asked you to review the relevant accounting literature and prepare a memo containing your recommendations. Support
your recommendations with citations and quotations from the Accounting Standards Codification.
C2–4
Need for Consolidation Process
LO 2–5, 2–6
Communication
At a recent staff meeting, the vice president of marketing appeared confused. The controller had assured him that the parent company and each of the subsidiary
companies had properly accounted for all transactions during the year. After several other questions, he finally asked, “If it has been done properly, then why must
you spend so much time and make so many changes to the amounts reported by the individual companies when you prepare the consolidated financial statements
each month? You should be able to just add the reported balances together.”
Required
Prepare an appropriate response to help the controller answer the marketing vice president’s question.
C2–5
Account Presentation
LO 2–1
Research
Prime Company has been expanding rapidly and is now an extremely diversified company for its size. It currently owns three companies with manufacturing
facilities, two companies primarily in retail sales, a consumer finance company, and two natural gas pipeline companies. This has led to some conflict between the
company’s chief accountant and its treasurer. The treasurer advocates presenting no more than five assets and three liabilities on its balance sheet. The chief
accountant has resisted combining balances from substantially different subsidiaries and has asked for your assistance.
Required
Research the Accounting Standards Codification to see what guidance is provided and prepare a memo to the chief accountant with your findings. Include citations
to and quotations from the most relevant references. Include in your memo at least two examples of situations in which it may be inappropriate to combine similarappearing accounts of two subsidiaries.
C2–6
Consolidating an Unprofitable Subsidiary
LO 2–5, 2–6
Research
Amazing Chemical Corporation’s president had always wanted his own yacht and crew and concluded that Amazing Chemical should diversify its investments by
purchasing an existing boatyard and repair facility on the lakeshore near his summer home. He could then purchase a yacht and have a convenient place to store it
and have it repaired. Although the board of directors was never formally asked to approve this new venture, the president moved forward with optimism and a
rather substantial amount of corporate money to purchase full ownership of the boatyard, which had lost rather significant amounts of money each of the five prior
years and had never reported a profit for the original owners.
Not surprisingly, the boatyard continued to lose money after Amazing Chemical purchased it, and the losses grew larger each month. Amazing Chemical, a very
profitable chemical company, reported net income of $780,000 in 20X2 and $850,000 in 20X3 even though the boatyard reported net losses of $160,000 in 20X2 and
$210,000 in 20X3 and was fully consolidated.
Required
Amazing Chemical’s chief accountant has become concerned that members of the board of directors or company shareholders will accuse him of improperly
preparing the consolidated statements. The president does not plan to tell anyone about the losses, which do not show up in the consolidated income statement
that the chief accountant prepared. You have been asked to prepare a memo to the chief accountant indicating the way to include subsidiaries in the consolidated
income statement and to provide citations to or quotations from the Accounting Standards Codification that would assist the chief accountant in dealing with this
matter. You have also been asked to search the accounting literature to see whether any reporting requirements require disclosure of the boatyard in notes to the
financial statements or in management’s discussion and analysis.
page 83
EXERCISES
E2–1
Multiple-Choice Questions on Accounting for Equity Investments [AICPA
Adapted]
LO 2–2, 2–3
Select the correct answer for each of the following questions.
1. Peel Company received a cash dividend from a common stock investment. Should Peel report an increase in the investment account if it carries the investment
at fair value or if it uses the equity method of accounting?
Fair
Value Equity
a.
No
No
b.
Yes
Yes
c.
Yes
No
d.
No
Yes
2. In 20X0, Neil Company held the following investments in common stock:
25,000 shares of B&K Inc.’s 100,000 outstanding shares. Neil’s level of ownership gives it the ability to exercise significant influence over the financial and
operating policies of B&K.
6,000 shares of Amal Corporation’s 309,000 outstanding shares.
During 20X0, Neil received the following distributions from its common stock investments:
November 6
$30,000 cash dividend from B&K
November 11 $1,500 cash dividend from Amal
December 26 3 percent common stock dividend from Amal The closing price of this stock was $115 per share.
What amount of dividend revenue should Neil report for 20X0?
a. $1,500
b. $4,200
c. $31,500
d. $34,200
3. An investor uses the equity method to account for an investment in common stock. Assume that (1) the investor owns less than 50 percent of the outstanding
common stock of the investee, (2) the investee company reports net income and declares dividends during the year, (3) the fair value of the investee’s stock is
unchanged during the year, and (4) the investee’s net income is more than the dividends it declares. How would the investor’s investment in the common stock
of the investee company under the equity method differ at year-end from what it would have been if the investor had carried the investment at fair value?
a. The balance under the equity method is higher than it would have been if the investment was carried at fair value.
b. The balance under the equity method is lower than it would have been if the investment was carried at fair value.
c. The balance under the equity method is higher than it would have been if the investment was carried at fair value, but only if the investee company actually
paid the dividends before year-end.
d. The balance under the equity method is lower than it would have been if the investment was carried at fair value, but only if the investee company actually
paid the dividends before year-end.
4. A corporation exercises significant influence over an affiliate in which it holds a 40 percent common stock interest. If its affiliate completed a fiscal year
profitably but paid no dividends, how would this affect the investor corporation?
a. Result in an increased current ratio.
b. Result in increased earnings per share.
c. Increase asset turnover ratios.
d. Decrease book value per share.
page 84
E2–2
Multiple-Choice Questions on Intercorporate Investments
LO 2–4
Select the correct answer for each of the following questions.
1. Companies often acquire ownership in other companies using a variety of ownership arrangements. The investor should use equity-method reporting
whenever
a. The investor purchases voting common stock of the investee.
b. The investor has significant influence over the operating and financing decisions of the investee.
c. The investor purchases goods and services from the investee.
d. There is no differential included in an investment, the carrying value of the investment is less than the market value of the investee’s shares held by the
investor.
2. The carrying amount of an investment in stock correctly accounted for under the equity method is equal to
a. The original price paid to purchase the investment.
b. The original price paid to purchase the investment plus cumulative net income plus cumulative dividends declared by the investee since the date the
investment was acquired.
c. The original price paid to purchase the investment plus cumulative net income minus cumulative dividends declared by the investee since the date the
investment was acquired.
d. The original price paid to purchase the investment minus cumulative net income minus cumulative dividends declared by the investee since the date the
investment was acquired.
E2–3
Multiple-Choice Questions on Applying Equity Method [AICPA Adapted]
LO 2–3
Select the correct answer for each of the following questions.
1. On January 2, 20X3, Kean Company purchased a 30 percent interest in Pod Company for $250,000. Pod reported net income of $100,000 for 20X3 and declared
and paid a dividend of $10,000. Kean accounts for this investment using the equity method. In its December 31, 20X3, balance sheet, what amount should Kean
report as its investment in Pod?
a. $160,000
b. $223,000
c. $340,000
d. $277,000
2. Investor Inc. owns 40 percent of Alimand Corporation. During the calendar year 20X5, Alimand had net earnings of $100,000 and paid dividends of $10,000.
During 20X5, the market value of Alimand’s stock remained unchanged. Investor mistakenly recorded these transactions by carrying the investment at fair
value rather than using the equity method of accounting. What effect would this have on the investment account, net earnings, and retained earnings,
respectively?
a. Understate, overstate, overstate.
b. Overstate, understate, understate.
c. Overstate, overstate, overstate.
d. Understate, understate, understate.
3. A corporation using the equity method of accounting for its investment in a 40 percent-owned investee, which earned $20,000 and paid $5,000 in dividends,
made the following entries:
Investment in Investee
8,000
Income from Investee
8,000
Cash
2,000
Dividend Revenue
2,000
What effect will these entries have on the investor’s statement of financial position?
a. Financial position will be fairly stated.
b. Investment in the investee will be overstated, retained earnings will be understated.
c. Investment in the investee will be understated, retained earnings will be understated.
d. Investment in the investee will be overstated, retained earnings will be overstated.
page 85
E2–4
Carrying an Investment at Fair Value versus Equity Method Reporting
LO 2–4
Winston Corporation purchased 40 percent of the stock of Fullbright Company on January 1, 20X2, at underlying book value. During the period of January 1, 20X2,
through December 31, 20X4, the market value of Winston’s investment in Fullbright’s stock increased by $20,000 each year. The companies reported the following
operating results and dividend payments during the first three years of intercorporate ownership:
Required
Compute the net income reported by Winston for each of the three years, assuming it accounts for its investment in Fullbright by (a) carrying the investment at fair
value, or (b) using the equity method.
E2–5
Acquisition Price
LO 2–2, 2–3
Phillips Company bought 40 percent ownership in Jones Bag Company on January 1, 20X1, at underlying book value. During the period of January 1, 20X1, through
December 31, 20X3, the market value of Phillips’ investment in Jones’ stock increased by $2,000 each year. In 20X1, 20X2, and 20X3, Jones Bag reported the
following:
Year
Net Income
Dividends
20X1
$ 8,000
$15,000
20X2
12,000
10,000
20X3
20,000
10,000
The balance in Phillips Company’s investment account on December 31, 20X3, was $54,000.
Required
In each of the following independent cases, determine the amount that Phillips paid for its investment in Jones Bag stock assuming that Phillips accounted for its
investment by (a) carrying the investment at fair value, or (b) using the equity method.
E2–6
Investment Income
LO 2–2, 2–3
Ravine Corporation purchased 30 percent ownership of Valley Industries for $90,000 on January 1, 20X6, when Valley had capital stock of $240,000 and retained
earnings of $60,000. During the period of January 1, 20X6, through December 31, 20X9, the market value of Ravine’s investment in Valley’s stock increased by
$10,000 each year. The following data were reported by the companies for the years 20X6 through 20X9:
Required
a.
What net income would Ravine Corporation have reported for each of the years, assuming Ravine accounts for the intercorporate investment either by (a)
carrying the investment at fair value, or by (b) using the equity method?
b.
Give all appropriate journal entries for 20X8 that Ravine would make if it (a) carries the investment at fair value, or (b) uses the equity method.
page 86
E2–7
Investment Value
LO 2–3
Port Company purchased 30,000 of the 100,000 outstanding shares of Sund Company common stock on January 1, 20X2, for $180,000. The purchase price was equal
to the book value of the shares purchased. Sund reported the following:
Year
Net Income
Dividends
20X2
$40,000
$25,000
20X3
30,000
20X4
5,000
Required
Compute the amounts Port Company should report as the carrying values of its investment in Sund Company at December 31, 20X2, 20X3, and 20X4.
E2–8
Carrying an Investment at Fair Value versus Equity Method Reporting
LO 2–2, 2–4
Small Company reported 20X7 net income of $40,000 and paid dividends of $15,000 during the year. Mock Corporation acquired 20 percent of Small’s shares on
January 1, 20X7, for $105,000. At December 31, 20X7, Mock determined the fair value of the shares of Small to be $121,000. Mock reported operating income of
$90,000 for 20X7.
Required
Compute Mock’s net income for 20X7 assuming it
a.
Carries the investment in Small at fair value.
b.
Uses the equity method of accounting for its investment in Small.
E2–9
Carrying an Investment at Fair Value versus Equity Method Reporting
LO 2–2, 2–3
Kent Company purchased 35 percent ownership of Lomm Company on January 1, 20X8, for $140,000. Lomm reported 20X8 net income of $80,000 and paid dividends
of $20,000. At December 31, 20X8, Kent determined the fair value of its investment in Lomm to be $174,000.
Required
Give all journal entries recorded by Kent with respect to its investment in Lomm in 20X8 assuming it
a.
Uses the equity method.
b.
Carries the securities at fair value method.
E2–10
Basic Consolidation Entry
LO 2–6
On December 31, 20X3, Broadway Corporation reported common stock outstanding of $200,000, additional paid-in capital of $300,000, and retained earnings of
$100,000. On January 1, 20X4, Johe Company acquired control of Broadway in a business combination.
Required
Give the consolidation entry that would be needed in preparing a consolidated balance sheet immediately following the combination if Johe acquired all of
Broadway’s outstanding common stock for $600,000.
E2–11
Balance Sheet Worksheet
LO 2–5, 2–6
Blank Corporation acquired 100 percent of Faith Corporation’s common stock on December 31, 20X2, for $150,000. Data from the balance sheets of the two
companies included the following amounts as of the date of acquisition:
Item
Blank Corporation
Cash
Faith Corporation
$ 65,000
$ 18,000
87,000
37,000
Inventory
110,000
60,000
Buildings & Equipment (net)
220,000
150,000
Investment in Faith Corporation Stock
150,000
Accounts Receivable
Total Assets
$632,000
$265,000
Accounts Payable
$ 92,000
$ 35,000
Notes Payable
150,000
80,000
Common Stock
100,000
60,000
Retained Earnings
290,000
90,000
$632,000
$265,000
Total Liabilities & Stockholders’ Equity
page 87
At the date of the business combination, the book values of Faith’s net assets and liabilities approximated
fair value. Assume that Faith Corporation’s accumulated depreciation on buildings and equipment on the
acquisition date was $30,000.
Required
a.
Give the consolidation entry or entries needed to prepare a consolidated balance sheet immediately following the business combination.
b.
Prepare a consolidated balance sheet worksheet.
E2–12
Consolidation Entries for Wholly Owned Subsidiary
LO 2–3, 2–6
Trim Corporation acquired 100 percent of Round Corporation’s voting common stock on January 1, 20X2, for $400,000. At that date, the book values and fair values
of Round’s assets and liabilities were equal. Round reported the following summarized balance sheet data:
Assets
$700,000
Accounts Payable
Bonds Payable
$100,000
200,000
Total
$700,000
Common Stock
120,000
Retained Earnings
280,000
Total
$700,000
Round reported net income of $80,000 for 20X2 and paid dividends of $25,000.
Required
a.
Give the journal entries recorded by Trim Corporation during 20X2 on its books if Trim accounts for its investment in Round using the equity method.
b.
Give the consolidation entries needed at December 31, 20X2, to prepare consolidated financial statements.
E2–13
Basic Consolidation Entries for Fully Owned Subsidiary
LO 2–3, 2–6
Amber Corporation reported the following summarized balance sheet data on December 31, 20X6:
Assets
Total
$600,000
$600,000
Liabilities
$100,000
Common Stock
300,000
Retained Earnings
200,000
Total
$600,000
On January 1, 20X7, Purple Company acquired 100 percent of Amber’s stock for $500,000. At the acquisition date, the book values and fair values of Amber’s assets
and liabilities were equal. Amber reported net income of $50,000 for 20X7 and paid dividends of $20,000.
Required
a.
Give the journal entries recorded by Purple on its books during 20X7 if it accounts for its investment in Amber using the equity method.
b.
Give the consolidation entries needed on December 31, 20X7, to prepare consolidated financial statements.
page 88
E2–14A
Income Reporting
LO 2–2, 2–3
Grandview Company purchased 40 percent of the stock of Spinet Corporation on January 1, 20X8, at underlying book value. Spinet recorded the following income
for 20X9:
Income before Discontinued Operations $60,000
Income from Discontinued Operations
Net Income
30,000
$90,000
Required
Prepare all journal entries on Grandview’s books for 20X9 to account for its investment in Spinet.
E2–15A
Investee with Preferred Stock Outstanding
LO 2–2, 2–3
Reden Corporation purchased 45 percent of Montgomery Company’s common stock on January 1, 20X9, at underlying book value of $288,000. Montgomery’s
balance sheet contained the following stockholders’ equity balances:
Preferred Stock ($5 par value, 50,000 shares issued and outstanding) $250,000
Common Stock ($1 par value, 150,000 shares issued and outstanding)
150,000
Additional Paid-In Capital
180,000
Retained Earnings
310,000
Total Stockholders’ Equity
$890,000
Montgomery’s preferred stock is cumulative and pays a 10 percent annual dividend. Montgomery reported net income of $95,000 for 20X9 and paid total dividends
of $40,000.
Required
Give the journal entries recorded by Reden Corporation for 20X9 related to its investment in Montgomery Company common stock.
E2–16A
Other Comprehensive Income Reported by Investee
LO 2–2, 2–3
Callas Corporation paid $380,000 to acquire 40 percent ownership of Thinbill Company on January 1, 20X9. The amount paid was equal to Thinbill’s underlying book
value. During 20X9, Thinbill reported operating income of $45,000 and income of $20,000 from gains on derivative contracts that were designated as cash flow
hedges, so these gains were reported in Other Comprehensive Income (OCI). Thinbill paid dividends of $9,000 on December 10, 20X9.
Required
Give all journal entries that Callas Corporation recorded in 20X9, including closing entries at December 31, 20X9, associated with its investment in Thinbill Company.
E2–17A
Other Comprehensive Income Reported by Investee
LO 2–2, 2–3
Baldwin Corporation purchased 25 percent of Gwin Company’s common stock on January 1, 20X8, at underlying book value. In 20X8, Gwin reported a net loss of
$20,000 and paid dividends of $10,000, and in 20X9, Gwin reported net income of $68,000 and paid dividends of $16,000. During year 20X9, Gwin reported a $12,000
gain on futures contracts which were designated as cash flow hedges, hence this gain was reported in Other Comprehensive Income (OCI) for the year ended
December 31, 20X9. Baldwin reported a balance of $67,000 in its investment in Gwin at December 31, 20X9.
Required
Compute the amount paid by Baldwin Corporation to purchase the shares of Gwin Company.
page 89
PROBLEMS
P2–18
Changes in the Number of Shares Held
LO 2–2, 2–3
Idle Corporation has been acquiring shares of Fast Track Enterprises at book value for the last several years. Fast Track provided data including the following:
Fast Track declares and pays its annual dividend on November 15 each year. Its net book value on January 1, 20X2, was $250,000. Idle purchased shares of Fast
Track on three occasions:
Date
January 1, 20X2
July 1, 20X3
January 1, 20X5
Percent of Ownership
Purchased
Amount Paid
10%
$25,000
5
15,000
10
34,000
Required
Give the journal entries to be recorded on Idle’s books in 20X5 related to its investment in Fast Track.
P2–19
Investments Carried at Fair Value and Equity Method
LO 2–2, 2–4
Gant Company purchased 20 percent of the outstanding shares of Temp Company for $70,000 on January 1, 20X6. The following results are reported for Temp
Company:
20X6
20X7
20X8
$40,000
$35,000
$60,000
15,000
30,000
20,000
January 1
70,000
89,000
86,000
December 31
89,000
86,000
97,000
Net Income
Dividends Paid
Fair Value of Shares Held by Gant:
Required
Determine the amounts reported by Gant as income from its investment in Temp for each year and the balance in Gant’s investment in Temp at the end of each year
assuming that Gant uses the following options in accounting for its investment in Temp:
a.
Carries the investment at fair value.
b.
Uses the equity method
P2–20
Carried at Fair Value Journal Entries
LO 2–2
Marlow Company acquired 40 percent of the voting shares of Brown Company on January 1, 20X8, for $85,000. The following results are reported for Brown
Company:
20X8
20X9
$20,000
$30,000
10,000
15,000
January 1
85,000
97,000
December 31
97,000
92,000
Net Income
Dividends Paid
Fair Value of Shares Held by Marlow:
Required
Give all journal entries recorded by Marlow for 20X8 and 20X9 assuming that it carries its investment in Brown at fair value.
page 90
P2–21
Consolidated Worksheet at End of the First Year of Ownership (Equity
Method)
LO 2–3, 2–5, 2–6
Peanut Company acquired 100 percent of Snoopy Company’s outstanding common stock for $300,000 on January 1, 20X8, when the book value of Snoopy’s net
assets was equal to $300,000. Peanut uses the equity method to account for investments. Trial balance data for Peanut and Snoopy as of December 31, 20X8, are as
follows:
Required
a.
Prepare the journal entries on Peanut’s books for the acquisition of Snoopy on January 1, 20X8, as well as any normal equity-method entry(ies) related to the
investment in Snoopy Company during 20X8.
b.
Prepare a consolidation worksheet for 20X8 in good form.
P2–22
Consolidated Worksheet at End of the Second Year of Ownership (Equity
Method)
LO 2–3, 2–5, 2–6
Peanut Company acquired 100 percent of Snoopy Company’s outstanding common stock for $300,000 on January 1, 20X8, when the book value of Snoopy’s net
assets was equal to $300,000. Problem 2-21 summarizes the first year of Peanut’s ownership of Snoopy. Peanut uses the equity method to account for investments.
The following trial balance summarizes the financial position and operations for Peanut and Snoopy as of December 31, 20X9:
Required
a.
Prepare any equity-method journal entry(ies) related to the investment in Snoopy Company during 20X9.
b.
Prepare a consolidation worksheet for 20X9 in good form.
page 91
P2–23
Consolidated Worksheet at End of the First Year of Ownership (Equity
Method)
LO 2–3, 2–5, 2–6
Paper Company acquired 100 percent of Scissor Company’s outstanding common stock for $370,000 on January 1, 20X8, when the book value of Scissor’s net
assets was equal to $370,000. Paper uses the equity method to account for investments. Trial balance data for Paper and Scissor as of December 31, 20X8, are as
follows:
Required
a.
Prepare the journal entries on Paper’s books for the acquisition of Scissor on January 1, 20X8, as well as any normal equity-method entry(ies) related to the
investment in Scissor Company during 20X8.
b.
Prepare a consolidation worksheet for 20X8 in good form.
P2–24
Consolidated Worksheet at End of the Second Year of Ownership (Equity
Method)
LO 2–3, 2–5, 2–6
Paper Company acquired 100 percent of Scissor Company’s outstanding common stock for $370,000 on January 1, 20X8, when the book value of Scissor’s net
assets was equal to $370,000. Problem 2-23 summarizes the first year of Paper’s ownership of Scissor. Paper uses the equity method to account for investments. The
following trial balance summarizes the financial position and operations for Paper and Scissor as of December 31, 20X9:
page 92
Required
a.
Prepare any equity-method journal entry(ies) related to the investment in Scissor Company during 20X9.
b.
Prepare a consolidation worksheet for 20X9 in good form.
P2–25A
Other Comprehensive Income Reported by Investee
LO 2–2
Dewey Corporation owns 30 percent of the common stock of Jimm Company, which it purchased at underlying book value on January 1, 20X5. Dewey reported a
balance of $245,000 for its investment in Jimm Company on January 1, 20X5, and $276,800 at December 31, 20X5. During 20X5, Dewey and Jimm Company reported
operating income of $340,000 and $70,000, respectively. Jimm received dividends from investments in marketable equity securities in the amount of $7,000 during
20X5. It also reported an increase of $18,000 in its portfolio of securities which were carried fair value, and a gain in the fair value of derivative contracts which were
appropriately designated as cash flow hedges, hence this gain was reported in Other Comprehensive Income (OCI). Jimm paid dividends of $20,000 in 20X5. Ignore
income taxes in determining your solution.
Required
a.
Assuming that Dewey uses the equity method in accounting for its investment in Jimm, compute the amount of income from Jimm recorded by Dewey in 20X5.
b.
Compute the amount reported by Jimm as other comprehensive income in 20X5.
P2–26A
Equity-Method Income Statement
LO 2–3, 2–6
Wealthy Manufacturing Company purchased 40 percent of the voting shares of Diversified Products Corporation on March 23, 20X4. On December 31, 20X8,
Wealthy Manufacturing’s controller attempted to prepare income statements and retained earnings statements for the two companies using the following
summarized 20X8 data:
Wealthy Manufacturing
Diversified Products
$850,000
$400,000
670,000
320,000
Other Expenses
90,000
25,000
Dividends Declared & Paid
30,000
10,000
Retained Earnings, 1/1/X8
420,000
260,000
Net Sales
Cost of Goods Sold
Wealthy Manufacturing uses the equity method in accounting for its investment in Diversified Products. The controller was also aware of the following specific
transactions for Diversified Products in 20X8, which were not included in the preceding data:
1. Diversified sold its entire Health Technologies division on September 30, 20X8, for $375,000. The book value of Health Technologies division’s net assets on
that date was $331,000. The division incurred an operating loss of $15,000 in the first nine months of 20X8.
2. During 20X8, Diversified sold one of its delivery trucks after it was involved in an accident and recorded a gain of $10,000.
page 93
Required
a.
Prepare an income statement and retained earnings statement for Diversified Products for 20X8.
b.
Prepare an income statement and retained earnings statement for Wealthy Manufacturing for 20X8.
P2–27B
Consolidated Worksheet at End
(Investment Carried at Cost)
of
the
First
Year
of
Ownership
LO 2–2, 2–5, 2–6
Peanut Company acquired 100 percent of Snoopy Company’s outstanding common stock for $300,000 on January 1, 20X8, when the book value of Snoopy’s net
assets was equal to $300,000. Peanut chooses to carry the investment in Snoopy at cost because the investment will be consolidated. Trial balance data for Peanut
and Snoopy as of December 31, 20X8, are as follows:
Required
a.
Prepare the journal entries on Peanut’s books for the acquisition of Snoopy on January 1, 20X8, as well as any other enries related to the investment in Snoopy
Company during 20X8.
b.
Prepare a consolidation worksheet for 20X8 in good form.
P2–28B
Consolidated Worksheet at End
(Investment Carried at Cost)
of
the
Second
Year
of
Ownership
LO 2–2, 2–5, 2–6
Peanut Company acquired 100 percent of Snoopy Company’s outstanding common stock for $300,000 on January 1, 20X8, when the book value of Snoopy’s net
assets was equal to $300,000. Problem 2-27B summarizes the first year of Peanut’s ownership of Snoopy. Peanut chooses to carry the investment in Snoopy at cost
because the investment will be consolidated. The following trial balance summarizes the financial position and operations for Peanut and Snoopy as of December
31, 20X9:
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Required
a.
Prepare any journal entry(ies) related to the investment in Snoopy Company during 20X9.
b.
Prepare a consolidation worksheet for 20X9 in good form.
ROGER CPA REVIEW
Sample CPA Exam questions from Roger CPA Review are available in Connect as support for the topics in this chapter. These Multiple Choice Questions and TaskBased Simulations include expert-written explanations and solutions, and provide a starting point for students to become familiar with the content and functionality
of the actual CPA Exam.
Situation
For each parent–subsidiary relationship, determine the proper accounting treatment.
Topics Covered in the Simulation
a.
Consolidation requirements.
b.
Consolidation exceptions.
1
Guidance on accounting for financial instruments, and the recognition and measurement of financial assets
and financial liabilities, was modified by ASU 2016-01. For public business entities, the amendments in this
update are effective for fiscal years beginning after December 15, 2017. The updated guidance from ASU 201601, which is specific to accounting for equity securities, is codified into ASC 321. The discussion of
accounting for equity securities in this text follows the updated guidance in ASC 321. However, because
accounting for equity securities and the provisions of ASC 321 are normally discussed in Intermediate
Accounting, detailed coverage is not provided here.
2
Investments which are to be consolidated can also be carried at historical cost since (as explained later
in this chapter) the investment account is eliminated in the consolidated financial statements. While
carrying equity investments at historical cost or accounting for investments using the equity method are both
acceptable in accounting for a consolidated subsidiary, we advocate the use of the equity method because it
ensures that the parent company’s books accurately reflect everything on the subsidiary’s books.
Conceptually, the use of the equity method is a useful way to understand the notion of consolidating a
controlled subsidiary because the investment account is simply replaced by the detail on the subsidiary’s
balance sheet.
3
In this example, the entire dividend ($20,000) was declared and paid during December. If dividends had been
declared and paid quarterly, we would record dividends declared only after ABC’s acquisition of the XYZ
shares.
4
To view a video explanation of this topic, visit advancedstudyguide.com.
5
An optional format lists accounts with credit balance accounts first and those having debit balances listed
next.
6
7
Optionally, accounts can be separated and listed with debits first and then credits.
An affiliated company is one that is related to the company in question. For example, two corporations
controlled by the same parent company would be considered affiliates.
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3
The Reporting Entity and the
Consolidation of Less-than-WhollyOwned Subsidiaries with No
Differential
Multicorporate Entities
Business Combinations
Consolidation Concepts and Procedures
Intercompany Transfers
Additional Consolidation Issues
Multinational Entities
Reporting Requirements
Partnerships
Governmental and Not-for-Profit Entities
Corporations in Financial Difficulty
THE COCA-COLA COMPANY
Coca-Cola was created in 1886 by an Atlanta-based pharmacist, Dr. John S. Pemberton, and was served at the neighborhood pharmacy soda fountain for
five cents a glass. During its first year, sales averaged nine servings per day in Atlanta. As of 2017, the company estimates that 1.9 billion servings of CocaCola beverages are consumed daily worldwide. Coca-Cola has grown into a beverage empire, making it one of the most recognizable symbols of globalized
capitalism. Its portfolio of beverages features 21 brands worth over $1 billion each, including Sprite, Fanta, Powerade, and Dasani.
Coca-Cola’s distribution has long been impacted by U.S. global relations. In July 2005, Coca-Cola resumed operations in Iraq for the first time since the
Arab League boycotted the company in 1968. In 2012, Coca-Cola resumed business in Myanmar after 60 years of absence due to U.S.-imposed investment
sanctions. As of 2017, Coca-Cola is sold in every country in the world but two, Cuba and North Korea, due to long-term U.S. trade embargoes. (Ironically,
in 1906, Cuba became one of the first countries to bottle Coke outside the U.S.) The restoration of diplomatic relations between Cuba and the United States
that began in July 2015 with the meeting of U.S. President Barack Obama and Cuban President Raúl Castro may serve to restore the company’s presence on
the island.
In order to meet demand in a timely manner, Coca-Cola is produced and bottled all over the world. The majority of Coca-Cola’s bottlers are accounted
for as variable interest entities, where some are consolidated and others are not. Coca-Cola reported the requirements it considers when determining whether
to consolidate its variable interest entities (VIEs). In its most recent 10-K, Coca-Cola wrote:
“Additionally, there are situations in which consolidation is required even though the usual condition of consolidation (ownership of a majority voting
interest) does not apply. Generally, this occurs when an entity holds an interest in another business enterprise that was achieved through arrangements that do
not involve voting interests, which results in a disproportionate relationship between such entity’s voting interests in, and its exposure to the economic risks
and potential rewards of, the other business enterprise. This disproportionate relationship results in what is known as a variable interest, and the entity in
which we have the variable interest is referred to as a "VIE." An enterprise must consolidate a VIE if it is determined to be the primary beneficiary of the VIE.
The primary beneficiary has both (1) the power to direct the activities of the VIE that most significantly impact the entity’s economic performance, and (2)
page 96
the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE.”1
Coca-Cola has determined that some of its VIEs should be consolidated while others do not need to be consolidated. The majority of Coca-Cola’s
nonconsolidated VIEs are not consolidated because Coca-Cola does not maintain the power to direct the activities of the VIE. Variable interest entities are
discussed in detail in this chapter.
Coca-Cola must also consolidate all of the various brands and subsidiaries where it is able to exercise control. These brands and subsidiaries are
consolidated and reported using the equity method of accounting. This chapter introduces accounting rules that Coca-Cola and others must follow for
determining when a business entity must be consolidated. It also explores how the basic consolidation process differs when a subsidiary is only partially
owned rather than wholly owned, as discussed in Chapter 2.
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO 3–1
Understand and explain the usefulness and limitations of consolidated financial statements.
LO 3–2
Understand and explain how direct and indirect control influence the consolidation of a subsidiary.
LO 3–3
Understand and explain differences in the consolidation process when the subsidiary is not wholly owned.
LO 3–4
Make calculations for the consolidation of a less-than-wholly-owned subsidiary.
LO 3–5
Prepare a consolidation worksheet for a less-than-wholly-owned subsidiary.
LO 3–6
Understand and explain the purpose of combined financial statements and how they differ from consolidated financial statements.
LO 3–7
Understand and explain rules related to the consolidation of variable interest entities.
LO 3–8
Understand and explain differences in consolidation rules under U.S. GAAP and IFRS.
THE USEFULNESS OF CONSOLIDATED FINANCIAL STATEMENTS
L O 3 –1
Understand and explain the usefulness and limitations of consolidated financial statements.
Chapter 2 provides an introduction to the consolidation process and introduces an example of a basic consolidation. This chapter expands the consolidation
discussion by exploring more complex situations in which the parent company does not have complete ownership of the subsidiary. Companies provide
consolidated financial statements primarily for parties having a long-run interest in the parent company, including the parent’s shareholders, creditors, and
other resource providers. Consolidated statements often provide the only means of obtaining a clear picture of the total resources of the combined entity that
are under the parent’s control and the results of employing those resources. Especially when the number of related companies is substantial, consolidated
statements are the only way to conveniently summarize the vast amount of information relating to the individual companies and how the financial positions
and operations of these companies affect the overall consolidated entity.
Current and prospective stockholders of the parent company are usually more interested in the consolidated financial statements than those of the
individual companies because the well-being of the parent company is affected by its subsidiaries’ operations. When subsidiaries are profitable, profits accrue
to the parent. However, the parent cannot escape the ill effects of unprofitable subsidiaries. By examining the consolidated statements, owners and potential
owners are better able to assess how effectively management employs all the resources under its control.
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The parent’s long-term creditors also find the consolidated statements useful because the effects of subsidiary operations on the overall health and future
of the parent are relevant to their decisions. In addition, although the parent and its subsidiaries are separate companies, the parent’s creditors have an indirect
claim on the subsidiaries’ assets.
The parent company’s management has a continuing need for current information about the combined operations of the consolidated entity in addition to
details about the individual companies forming the consolidated entity. For example, some of the individual subsidiaries might have substantial volatility in their
operations. As a result, the manager may not be able to fully understand the overall impact of the activities for the period until the operating results and
balance sheets are combined into consolidated financial statements. On the other hand, information about individual companies within the consolidated entity
also may be useful. For example, it may allow a manager to offset a cash shortfall in one subsidiary with excess cash from another without resorting to
costly outside borrowing. The parent company’s management may be particularly concerned with the consolidated financial statements because top
management generally is evaluated, and sometimes compensated, based on the overall performance of the entity as reflected in the consolidated statements.
LIMITATIONS OF CONSOLIDATED FINANCIAL STATEMENTS
Although consolidated financial statements are useful, their limitations also must be kept in mind. Some information is lost any time data sets are aggregated;
this is particularly true when the information involves an aggregation across companies that have substantially different operating characteristics. Some of the
more important limitations of consolidated financial statements are
1. The masking of poor performance. Because the operating results and financial position of individual companies included in the consolidation are not disclosed,
the poor performance or financial position of one or more companies may be hidden by the good performance and financial position of others.
2. Limited availability of resources. Not all of the consolidated retained earnings balance is necessarily available for dividends of the parent because a portion may
represent the parent’s share of undistributed subsidiary earnings. Similarly, because the consolidated statements include the subsidiary’s assets, not all assets
shown are available for dividend distributions of the parent company.
3. Unrepresentative combined financial ratios. Because financial ratios based on the consolidated statements are calculated on aggregated information, they are not
necessarily representative of any single company in the consolidation, including the parent.
4. A lack of uniformity. Similar accounts of different companies that are combined in the consolidation may not be entirely comparable. For example, the length of
operating cycles of different companies may vary, causing receivables of similar length to be classified differently.
5. The lack of detailed disclosures. Additional information about individual companies or groups of companies included in the consolidation often is necessary for a
fair presentation; such additional disclosures may require voluminous footnotes.
SUBSIDIARY FINANCIAL STATEMENTS
Some financial statement users may be interested in the separate financial statements of individual subsidiaries, either instead of or in addition to consolidated
financial statements. Although the parent company’s management is concerned with the entire consolidated entity as well as individual subsidiaries, the
creditors, preferred stockholders, and noncontrolling common stockholders of subsidiary companies are most interested in the separate financial statements
of the subsidiaries in which they have an interest. Because subsidiaries are legally separate from their parents, a subsidiary’s creditors and page 98
stockholders generally have no claim on the parent, and the subsidiary’s stockholders do not share in the parent’s profits unless the parent has
provided guarantees or entered into other arrangements for the benefit of the subsidiaries. Therefore, consolidated financial statements usually are of little use
to those interested in obtaining information about the assets, capital, or income of individual subsidiaries.
CONSOLIDATED FINANCIAL STATEMENTS: CONCEPTS AND STANDARDS
L O 3 –2
Understand and explain how direct and indirect control influence the consolidation of a subsidiary.
Consolidated financial statements are intended to provide a meaningful representation of the overall financial position and activities of a single economic entity
comprising a number of related companies. Under current standards, subsidiaries must be consolidated unless the parent is precluded from exercising
control. When it is not appropriate to consolidate a subsidiary, it is reported as an intercompany investment (ASC 810).
Traditional View of Control
Over the years, the concept of control has been the single most important criterion for determining when an individual subsidiary should be consolidated.
ASC 810 indicates that consolidated financial statements normally are appropriate for a group of companies when one company “has a controlling financial
interest in the other companies.” It also states that “the usual condition for a controlling financial interest is ownership of a majority voting interest. . . .” In
practice, control has been determined by the proportion of voting shares of a company’s stock owned directly or indirectly by another company. This
criterion was formalized by ASC 810, which requires consolidation of all majority-owned subsidiaries unless the parent is unable to exercise control.
Although majority ownership is the most common means of acquiring control, a company may be able to direct the operating and financing policies of
another with less than majority ownership, such as when the remainder of the stock is widely held. ASC 810 does not preclude consolidation with less than
majority ownership, but the consolidation of less-than-majority-owned subsidiaries is very rare in practice. More directly, ASC 810 indicates that control can
be obtained without majority ownership of a company’s common stock.
Indirect Control 2
The traditional view of control includes both direct and indirect control. Direct control typically occurs when one company owns a majority of another
company’s common stock. Indirect control or pyramiding occurs when a company’s common stock is owned by one or more other companies that are all
under common control. In each of the following examples, P Company controls Z Company. However, in each case, P Company does not own a direct
interest in Z. Instead, P controls Z indirectly through the ownership of other companies.
FYI
Towards the end of 2016, AT&T announced a planned acquisition of Time Warner for $85.4 billion. Thencandidate Donald Trump repeatedly singled out this deal as the kind of combination he would not allow as
President. However, on February 15, 2017, 78 percent of Time Warner shareholders cast a vote in support of
the proposed transaction, setting the stage for the federal government’s review of the deal. In its 2016
10-K filing, Time Warner stated it maintains approximately 900 subsidiaries which are “at least 50
percent owned, directly or indirectly.” Therefore, if this deal is ultimately approved, AT&T will
directly or indirectly control hundreds of new entities.
In (1), P owns 80 percent of X, which owns 60 percent of Z. Because P controls X and X controls Z, P indirectly controls Z. In (2), P owns 90 percent
of X and 70 percent of Y; X owns 40 percent of Z; Y owns 30 percent of Z. Because P controls both X and Y and they, in turn, jointly control Z (with a
combined ownership of 70 percent), P effectively controls Z through its two subsidiaries. In (3), P owns 90 percent of X and 80 percent of Y;
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X owns 80 percent of W and 30 percent of Z; Y owns 15 percent of Z; W owns 15 percent of Z. Because P controls both X and Y and they,
in turn, jointly control Z (with a combined control of 60 percent—15 percent of which comes through X’s subsidiary W), P effectively controls Z through its
two subsidiaries. In each case, P controls Z through its subsidiaries.
Ability to Exercise Control
Under certain circumstances, a subsidiary’s majority stockholders may not be able to exercise control even though they hold more than 50 percent of its
outstanding voting stock. This might occur, for instance, if the subsidiary was in legal reorganization or in bankruptcy; although the parent might hold
majority ownership, control would rest with the courts or a court-appointed trustee. Similarly, if the subsidiary were located in a foreign country and that
country had placed restrictions on the subsidiary that prevented the remittance of profits or assets back to the parent company, consolidation of that
subsidiary would not be appropriate because of the parent’s inability to control important aspects of the subsidiary’s operations.
Differences in Fiscal Periods
A difference in the fiscal periods of a parent and subsidiary should not preclude consolidation of that subsidiary. Often the subsidiary’s fiscal period, if
different from the parent’s, is changed to coincide with that of the parent. Another alternative is to adjust the financial statement data of the subsidiary each
period to place the data on a basis consistent with the parent’s fiscal period. Both the Securities and Exchange Commission and current accounting standards
permit the consolidation of a subsidiary’s financial statements without adjusting the fiscal period of the subsidiary if that period does not differ from the
parent’s by more than three months and if recognition is given to intervening events that have a material effect on financial position or results of operations.
Changing Concept of the Reporting Entity
For nearly three decades beginning in the 1960s, little change was observed in the authoritative literature governing consolidation policies. However, during
that time, many changes occurred in the business environment, including widespread diversification of companies and the increased emphasis on financial
services by manufacturing and merchandising companies (such as General Electric and Harley-Davidson).
In addition, the criteria used in determining whether to consolidate specific subsidiaries were subject to varying interpretations. Companies exercised great
latitude in selecting which subsidiaries to consolidate and which to report as intercorporate investments. The lack of consistency in consolidation policy
became of increasing concern as many manufacturing and merchandising companies engaged in “off-balance sheet financing” by borrowing
page 100
heavily through finance subsidiaries and then excluding those subsidiaries from consolidation.
In 1982, the FASB began a project aimed at developing a comprehensive consolidation policy. The guidance in ASC 810 was developed in 1987, requiring
the consolidation of all majority-owned subsidiaries. The intent was to eliminate the inconsistencies found in practice until a more comprehensive standard
could be issued. Unfortunately, the issues have been more difficult to resolve than anticipated. After grappling with these issues for more than two decades,
the FASB has still been unable to provide a comprehensive consolidation policy.
Completion of the FASB’s consolidation project has been hampered by, among other things, the inability to resolve issues related to two important
concepts: (1) control and (2) the reporting entity. Regarding the first issue, the FASB has attempted to move beyond the traditional notion of control based on
majority ownership of common stock to requiring consolidation of entities under effective control. This idea reflects the ability to direct the policies of
another entity even though majority ownership is lacking. Adopting the concept of effective control can lead to the consolidation of companies in which little
or even no ownership is held and to the consolidation of entities other than corporations, such as partnerships and trusts. Although the FASB has indicated in
ASC 805 that control can be achieved without majority ownership, a comprehensive consolidation policy has yet to be achieved.
With respect to the second issue, defining the accounting entity would go a long way toward resolving the issue of when to prepare consolidated financial
statements and what entities should be included. Unfortunately, the FASB has found both the entity and control issues so complex that they are not easily
resolved and require further study. Accordingly, the FASB issued guidance dealing with selected issues related to consolidated financial statements (ASC
810), leaving a comprehensive consolidation policy until a later time.
NONCONTROLLING INTEREST
L O 3 –3
Understand and explain differences in the consolidation process when the subsidiary is not wholly owned.
A parent company does not always own 100 percent of a subsidiary’s outstanding common stock. The parent may have acquired less than 100 percent of a
company’s stock in a business combination, or it may originally have held 100 percent but sold or awarded some shares to others. For the parent to
consolidate the subsidiary, only a controlling interest is needed. Those shareholders of the subsidiary other than the parent are referred to as noncontrolling
shareholders. The claim of these shareholders on the income and net assets of the subsidiary is referred to as the noncontrolling interest (formerly referred
to as the minority interest). 3 Throughout this chapter and in subsequent chapters, whenever the acquired company is less than wholly owned, we will
frequently refer to the noncontrolling interest shareholders as the NCI shareholders. The NCI shareholders clearly have a claim on the subsidiary’s assets and
earnings through their stock ownership. Because 100 percent of a subsidiary’s assets, liabilities, and earnings is included in the consolidated financial
statements, regardless of the parent’s percentage ownership, the NCI shareholders’ claim on these items must be reported.
Computation and Presentation of Noncontrolling Interest
In uncomplicated situations, the noncontrolling interest’s share of consolidated net income is a simple proportionate share of the subsidiary’s net income. For
example, if a subsidiary has net income of $150,000 and the NCI shareholders own 10 percent of the subsidiary’s common stock, their share of income is
$15,000 ($150,000 × 0.10).
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The NCI shareholders’ claim on the net assets of the subsidiary is based on the acquisition-date fair value of the noncontrolling interest, adjusted over
time for a proportionate share of the subsidiary’s income and dividends. We discuss the noncontrolling interest in more detail in Chapter 5.
The current standard on reporting noncontrolling interests, ASC 810, requires that the term consolidated net income be applied to the income available to
all stockholders, with the allocation of that income between the controlling and noncontrolling stockholders included in the consolidated income statement.
For example, assume that Parent Company owns 90 percent of Sub Company’s stock, acquired without a differential, and that the two companies report
revenues and expenses as follows:
Parent
Sub
Revenues
$300,000
$100,000
Expenses
225,000
65,000
An abbreviated consolidated income statement for Parent and its subsidiary would appear as follows:
Revenues
$ 400,000
Expenses
(290,000)
Consolidated Net Income
$ 110,000
Less: Consolidated Net Income Attributable to the Noncontrolling Interest in Sub Company
Consolidated Net Income Attributable to the Controlling Interest in Sub Company
(3,500)
$ 106,500
Also assume that Parent’s beginning retained earnings is $200,500, common stock is $50,000, additional paid-in capital is $700,000, and dividends
declared and paid by the parent this period are $27,000. The noncontrolling interest’s claim on the net assets of the subsidiary was previously reported in the
balance sheet, most frequently in the “mezzanine” between liabilities and stockholders’ equity. Some companies reported the noncontrolling interest as a
liability, although it clearly did not meet the definition of a liability. ASC 810 is clear that the noncontrolling interest’s claim on net assets is an element of
equity, not a liability. It requires reporting the noncontrolling interest in equity in the following manner:
Controlling Interest:
Common Stock
$
50,000
Additional Paid-In Capital
700,000
Retained Earnings
280,000
Total Controlling Interest
$1,030,000
Noncontrolling Interest in the Net Assets of Sub Company
Total Stockholders’ Equity
75,000
$1,105,000
FYI
In Berkshire Hathaway’s 2016 consolidated income statement, the company reported total consolidated net
income of $24.43 billion, which included $353 million in earnings attributable to noncontrolling
interests. Additionally, Berkshire’s 2016 consolidated balance sheet reported total noncontrolling
interests in net assets of $3.4 billion.
THE EFFECT OF A NONCONTROLLING INTEREST
L O 3 –4
Make calculations for the consolidation of a less-than-wholly-owned subsidiary.
When a subsidiary is less than wholly owned, the general approach to consolidation is the same as discussed in Chapter 2, but the consolidation procedures
must be modified slightly to recognize the noncontrolling interest. Thus, the difference between the consolidation procedures illustrated in Chapter 2 and
what we will demonstrate here is that we now have to account for the NCI shareholders’ ownership in the income and net assets of the acquired page 102
company. The following two-by-two matrix indicates that the only difference in consolidation in Chapter 3 relative to Chapter 2 is the separate
recognition of the NCI shareholder share of income and net assets.
Before examining the specific procedures used in consolidating a less-than-wholly-owned subsidiary, we discuss the computation of consolidated net
income, consolidated retained earnings, and the noncontrolling interest’s claim on income and net assets. We also discuss modifications to the consolidation
worksheet.
Consolidated Net Income
Consolidated net income, as it appears in the consolidated income statement, is the difference between consolidated revenues and expenses. In the absence of
transactions between companies included in the consolidation, consolidated net income is equal to the parent’s income from its own operations, excluding
any investment income from consolidated subsidiaries, plus the net income from each of the consolidated subsidiaries.
When all subsidiaries are wholly owned, all of the consolidated net income accrues to the parent company, or the controlling interest. If one or more of
the consolidated subsidiaries is less than wholly owned, a portion of the consolidated net income accrues to the NCI shareholders. In that case, the income
attributable to the subsidiary’s noncontrolling interest is deducted from consolidated net income on the face of the income statement to arrive at consolidated
net income attributable to the controlling interest.
Income attributable to a noncontrolling interest in a subsidiary is based on a proportionate share of that subsidiary’s net income. The subsidiary’s net
income available to common shareholders is divided between the parent and noncontrolling stockholders based on their relative common stock ownership of
the subsidiary. Note that the NCI shareholders in a particular subsidiary have a proportionate claim only on the income of that subsidiary and not on the
income of the parent or any other subsidiary.
As an example of the computation and allocation of consolidated net income, assume that Push Corporation purchases 80 percent of the stock of Shove
Company for an amount equal to 80 percent of Shove’s total book value. During 20X1, Shove reports separate net income of $25,000, while Push reports
net income of $120,000, including equity-method income from Shove of $20,000 ($25,000 × 0.80). Consolidated net income for 20X1 is computed and
allocated as follows:
Push’s net income
Less: Equity-method income from Shove
Shove’s net income
Consolidated net income
Income attributable to noncontrolling interest
Income attributable to controlling interest
$120,000
(20,000)
25,000
$125,000
(5,000)
$120,000
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Consolidated net income is equal to the separate income of Push from its own operations ($100,000) plus Shove’s net income ($25,000). The $20,000 of
equity-method income from Shove that had been recognized by Push must be excluded from the computation to avoid double-counting the same income.
Consolidated net income is allocated to the noncontrolling stockholders based on their 20 percent share of Shove’s net income. The amount of income
allocated to the controlling interest is equal to Push’s income from its own operations ($100,000) and Push’s 80 percent share of Shove’s income ($20,000)
because Push used the equity method of accounting for its investment in Shove.
Consolidated Retained Earnings
The retained earnings figure reported in the consolidated balance sheet is not entirely consistent with the computation of consolidated net income. Retained
earnings in the consolidated balance sheet is that portion of the consolidated entity’s undistributed earnings accruing to the parent’s stockholders. Assuming
the parent company correctly uses the fully adjusted equity method to account for its investments, consolidated retained earnings should equal the parent’s
retained earnings. It is calculated by adding the parent’s share of subsidiary cumulative net income since acquisition to the parent’s retained earnings from its
own operations (excluding any income from the subsidiary included in the parent’s retained earnings) and subtracting the parent’s share of any differential
write-off. Any retained earnings related to subsidiary NCI shareholders is included in the Noncontrolling Interest in Net Assets of Subsidiary amount reported
in the equity section of the consolidated balance sheet.
To illustrate the computation of consolidated retained earnings when a noncontrolling interest exists, assume that Push purchases 80 percent of Shove’s
stock on January 1, 20X1, and accounts for the investment using the equity method. Assume net income and dividends as follows during the two years
following the acquisition:
Push
Shove
$400,000
$250,000
Net income, 20X1
120,000
25,000
Dividends, 20X1
(30,000)
(10,000)
Retained earnings, January 1, 20X1
Retained earnings, December 31, 20X1 $490,000
$265,000
Net income, 20X2
148,000
35,000
Dividends, 20X2
(30,000)
(10,000)
Retained earnings, December 31, 20X2 $608,000
$290,000
Consolidated retained earnings as of two years after the date of combination is computed as follows:
Push’s retained earnings, December 31, 20X2
$608,000
Equity accrual from Shove since acquisition ($25,000 + $35,000) × 0.80
(48,000)
Push’s retained earnings from its own operations, December 31, 20X2
$560,000
Push’s share of Shove’s net income since acquisition ($60,000 × 0.80)
Consolidated retained earnings, December 31, 20X2
48,000
$608,000
We note several important points from the example. First, the subsidiary’s retained earnings are not combined with the parent’s retained earnings. Only
the parent’s share of the subsidiary’s cumulative net income since the date of combination is included. Second, consolidated retained earnings are equal to the
parent’s retained earnings because the parent uses the equity method to account for its investment in the subsidiary. If the parent accounted for the
investment using the cost method, the parent’s retained earnings and consolidated retained earnings would differ. Finally, we note that the consolidated
financial statements include the equity accounts of the parent. In the Push and Shove example, Push’s shareholders effectively control both Push and Shove.
Hence, Push’s equity accounts, along with the noncontrolling interest in Shove’s net assets, comprise the equity section of the consolidated
page 104
group of companies. For the same reason, only Push’s dividends influence consolidated retained earnings.
Worksheet Format
The same three-part worksheet described in Chapter 2 can be used when consolidating less-than-wholly-owned subsidiaries, with only minor modifications.
The worksheet must allow for including the noncontrolling interest’s claim on the income and net assets of the subsidiaries. The noncontrolling interest’s
claim on the income of a subsidiary is deducted from consolidated net income at the bottom of the worksheet’s income statement section in the Consolidated
column to arrive at consolidated net income attributable to the controlling interest. The noncontrolling interest’s claim on the subsidiary’s net assets is placed
at the bottom of the worksheet’s balance sheet section. The noncontrolling interest’s claims on both income and net assets are entered in the worksheet
through consolidation entries and then carried over to the Consolidated column. As discussed in Chapter 2, the amounts in the Consolidated column are used
to prepare the consolidated financial statements.
page 105
CONSOLIDATED BALANCE SHEET WITH A LESS-THAN-WHOLLY-OWNED SUBSIDIARY
L O 3 –5
Prepare a consolidation worksheet for a less-than-wholly-owned subsidiary.
In order to illustrate the consolidation process for a less-than-wholly-owned subsidiary, we use the Peerless-Special Foods example from Chapter 2. The only
difference is that we assume that instead of acquiring all of the common stock of Special Foods, Peerless buys only 80 percent of the shares. Thus, we
assume that the other 20 percent of the shares are widely held by other shareholders (the NCI shareholders).
80 Percent Ownership Acquired at Book Value
Peerless acquires 80 percent of Special Foods’ outstanding common stock for $240,000, an amount equal to 80 percent of the fair value of Special Foods’
net assets on January 1, 20X1. On this date, the fair values of Special Foods’ individual assets and liabilities are equal to their book values. Thus, there is no
differential. Because Peerless acquires only 80 percent of Special Foods’ common stock, the Investment in Special Foods equals 80 percent of the total
stockholders’ equity of Special Foods ($200,000 + $100,000). We can summarize Special Foods’ ownership as follows:
Peerless records the 80 percent stock acquisition on its books with the following entry on January 1, 20X1:
(1)
Investment in Special Foods
Cash
240,000
240,000
Record purchase of Special Foods stock.
The Basic Investment Consolidation Entry
The basic consolidation entry on the date of acquisition would be the same as the one illustrated in Chapter 2 except that the $300,000 book value of net
assets is now jointly owned by Peerless (80 percent) and the NCI shareholders (20 percent). Thus, the original $300,000 credit to the Investment in Special
Foods account from the wholly owned example in Chapter 2 is now “shared” with the NCI shareholders as shown in the breakdown of the book value of
Special Foods:
Because the fair value of Special Foods’ net assets on the acquisition date is equal to their book value, there is no differential. Thus, the only required
consolidation entry (the basic consolidation entry) in the worksheet removes the Investment in Special Foods Stock account and Special Foods’
stockholders’ equity accounts and records the $60,000 NCI interest in the net assets of Special Foods.
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In this example, Peerless’s investment is exactly equal to its 80 percent share of the book value of Special Foods’ net assets. Therefore, goodwill is not
recorded and all assets and liabilities are simply combined from Special Foods’ financial statements at their current book values. Again, in Chapters 4 and 5,
we will explore situations in which the acquiring company pays more than the book value of the acquired company’s net assets. However, in Chapters 2 and
3, the excess value of identifiable net assets and goodwill will always be equal to zero. To maintain a consistent approach through all four chapters, we
always illustrate the components of the acquiring company’s investment, even though the acquiring company’s investment will always be exactly equal to its
share of the book value of net assets in this chapter. Thus, the relationship between the fair value of the consideration given to acquire Special Foods, the fair
value of Special Foods’ net assets, and the book value of Special Foods’ net assets can be illustrated as follows:
The consolidation entry simply credits the Investment in Special Foods Stock account (for the original acquisition price, $240,000), eliminating this account
from Peerless’s balance sheet.
Remember that this entry is made in the consolidation worksheet, not on the books of either the parent or the subsidiary, and is presented here in T-account
form for instructional purposes only. The investment account must be eliminated in the consolidation process because, as explained in Chapter 2, from a
single-entity viewpoint, a company cannot hold an investment in itself. Stated differently, since the Investment in Special Foods account already summarizes
Special Foods’ entire balance sheet, adding the individual line items on Special Foods’ balance sheet together with Peerless’s balance sheet items would be
equivalent to double counting Special Foods’ balance sheet.
As explained in Chapter 2, we first examine situations where a subsidiary is created (hence the parent’s book values of transferred assets carry over) or
where the acquisition price is exactly equal to the book value of the target company’s net assets. When a parent company acquires a subsidiary, the
consolidated financial statements should appear as if all of the subsidiary’s assets and liabilities were acquired and recorded at their acquisition
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prices (equal to their former book values). If Peerless had purchased Special Foods’ assets instead of its stock with an acquisition price equal
to the book value of net assets, the assets would have been recorded in Peerless’s books at their acquisition prices (as if they were new assets with zero
accumulated depreciation). Following this logic, because Peerless did acquire Special Foods’ stock, the consolidated financial statements should present all of
Special Foods’ assets and liabilities as if they had been recorded at their acquisition prices and then depreciated from that date forward. Thus, eliminating the
old accumulated depreciation of the subsidiary as of the acquisition date and netting it out against the historical cost gives the appearance that the depreciable
assets have been newly recorded at their acquisition prices (which happen to be equal to Special Foods’ book values). In this example, Special Foods had
accumulated depreciation on the acquisition date of $300,000. Thus, as explained in Chapter 2, the following consolidation entry nets out this accumulated
depreciation against the cost of the building and equipment.
Also as explained in Chapter 2, this worksheet consolidation entry does not change the net buildings and equipment balance. Netting the preacquisition
accumulated depreciation out against the cost basis of the corresponding assets merely causes the buildings and equipment to appear in the consolidated
financial statements as if they had been recorded as new assets (which coincidentally happen to be equal to their former book values) on the acquisition date.
In this chapter and in Chapter 2, we assume that the fair values of all assets and liabilities are equal to their book values on the acquisition date. This same
entry would be included in each succeeding consolidation as long as the assets remain on Special Foods’ books (always based on the accumulated
depreciation balance as of the acquisition date).
Consolidation Worksheet
Figure 3–1 presents the consolidation worksheet. As explained previously in Chapter 2, the investment account on the parent’s books can be thought of as a
single account representing the parent’s investment in the net assets of the subsidiary, a one-line consolidation. In a full consolidation, the page 108
subsidiary’s individual assets and liabilities are combined with those of the parent. Including both the net assets of the subsidiary, as represented
by the balance in the investment account, and the subsidiary’s individual assets and liabilities would double-count the same set of assets. Therefore, the
investment account is eliminated and not carried to the consolidated balance sheet.
F I G U R E 3 –1
January 1, 20X1, Worksheet for Consolidated Balance Sheet, Date of Combination; 80 Percent Acquisition at Book Value
Figure 3–2 presents the consolidated balance sheet, prepared from the consolidation worksheet, as of the acquisition date. Because no operations
occurred between the date of combination and the preparation of the consolidated balance sheet, there is no income statement or statement of retained
earnings.
F I G U R E 3 –2
Consolidated Balance Sheet, January 1, 20X1, Date of Combination; 80 Percent Acquisition at Book Value
CONSOLIDATION SUBSEQUENT TO ACQUISITION—80 PERCENT OWNERSHIP
ACQUIRED AT BOOK VALUE
Chapter 2 explains the procedures used to prepare a consolidated balance sheet as of the acquisition date. More than a consolidated balance sheet, however, is
needed to provide a comprehensive picture of the consolidated entity’s activities following acquisition. As with a single company, the set of basic financial
statements for a consolidated entity consists of an income statement, a statement of changes in retained earnings, a balance sheet, and a statement of cash
flows. Each of the consolidated financial statements is prepared as if it is taken from a single set of books that is being used to account for the overall
consolidated entity. There is, of course, no set of books for the consolidated entity. Therefore, as in the preparation of the consolidated balance sheet, the
consolidation process starts with the data recorded on the books of the individual consolidating companies. The account balances from the books of the
individual companies are placed in the three-part worksheet, and entries are made to eliminate the effects of intercorporate ownership and transactions. The
consolidation approach and procedures are the same whether the subsidiary being consolidated was acquired or created.
Initial Year of Ownership
Assume that Peerless already recorded the acquisition on January 1, 20X1, and that during 20X1, Peerless records operating earnings of $140,000, excluding
its income from investing in Special Foods, and declares dividends of $60,000. Special Foods reports 20X1 net income of $50,000 and declares dividends of
$30,000.
Parent Company Entries
Peerless records its 20X1 income and dividends from Special Foods under the equity method as follows:
(2)
Investment in Special Foods
40,000
Income from Special Foods
40,000
Record Peerless’s 80% share of Special Foods’ 20X1 income.
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(3)
Cash
Investment in Special Foods
24,000
24,000
Record Peerless’s 80% share of Special Foods’ 20X1 dividend.
Consolidation Worksheet—Initial Year of Ownership
After all appropriate equity method entries have been recorded on Peerless’s books, the company can prepare a consolidation worksheet. Peerless begins the
worksheet by placing the adjusted account balances from both Peerless’s and Special Foods’ books in the first two columns of the worksheet. Then all
amounts that reflect intercorporate transactions or ownership are eliminated in the consolidation process.
The distinction between journal entries recorded on the books of the individual companies and the consolidation entries recorded only on the consolidation
worksheet is an important one. Book entries affect balances on the books and the amounts that are carried to the consolidation worksheet; worksheet
consolidation entries affect only those balances carried to the consolidated financial statements in the period. As mentioned previously, the consolidation
entries presented in this text are shaded when presented both in journal entry form in the text and in the worksheet.
In this example, the accounts that must be eliminated because of intercorporate ownership are the stockholders’ equity accounts of Special Foods
(including dividends declared), Peerless’s investment in Special Foods stock, and Peerless’s income from Special Foods. However, the book value portion of
Peerless’s investment has changed since the January 1 acquisition date because under the equity method, Peerless has adjusted the investment account
balance for its share of earnings and dividends (entries 2 and 3). The book value portion of the investment account can be summarized as follows:
Note that we use shaded fonts for the amounts in the book value analysis that appear in the basic consolidation entry.
Under the equity method, the parent recognized its share (80 percent) of the subsidiary’s income on its separate books. In the consolidated income
statement, however, the individual revenue and expense accounts of the subsidiary are combined with those of the parent. Income recognized by the parent
from all consolidated subsidiaries, therefore, must be eliminated to avoid double-counting. The subsidiary’s dividends must be eliminated when consolidated
statements are prepared so that only dividend declarations related to the parent’s shareholders are treated as dividends of the consolidated
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entity. Thus, the basic consolidation entry removes both the investment income reflected in the parent’s income statement and any dividends
declared by the subsidiary during the period:
Because there is no differential in this example, the basic consolidation entry completely eliminates the balance in Peerless’s investment account on the
balance sheet as well as the Income from Special Foods account on the income statement. Note again that the parent’s investment in the stock of a
consolidated subsidiary never appears in the consolidated balance sheet and the income from subsidiary account never appears on the consolidated income
statement.
As explained previously, we repeat the accumulated depreciation entry in each succeeding period for as long as the subsidiary owns these assets. The
purpose of this entry is to appropriately present these assets in the consolidated financial statements as if they had been purchased on the date the subsidiary
was acquired at their acquisition date fair values.
CAUTION
Note that the $10,000 debit to NCI in Net Income in the Consolidation Entries column of Figure 3–3 is
added to the $40,000 Consolidated Net Income debit subtotal to arrive at the total debit adjustments in
the Controlling Interest in the Net Income row. Students sometimes forget that the Consolidation Entries
columns simply add total debit and credit adjustments (ignoring the “formula” used in the income
calculation). The reason the $10,000 NCI in Net Income is listed with brackets in the Consolidated column
is because a debit decreases income.
Figure 3–3 presents the consolidation worksheet. We note that there are only two changes on the worksheet when the subsidiary is only partially owned
(Chapter 3) relative to when the subsidiary is wholly owned (Chapter 2). First, the income statement calculates the consolidated net income ($190,000 in this
example) and then deducts the portion attributable to the NCI shareholders (NCI in Net Income) to arrive at the portion attributable to the parent (controlling
interest). In this example, the final line of the income statement presents Peerless’s share of the consolidated net income, $180,000. This amount should
always equal the parent’s net income in the first column of the worksheet if the parent properly accounts for the investment in the subsidiary
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using the equity method on its own books. 4 Second, since the parent company consolidates the entire balance sheet of the subsidiary, it must
disclose the portion of the subsidiary’s net assets that belong to the noncontrolling interest (NCI in Net Assets).
F I G U R E 3 –3
December 31, 20X1, Equity-Method Worksheet for Consolidated Financial Statements, Initial Year of Ownership; 80 percent Acquisition
at Book Value
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Second and Subsequent Years of Ownership
The consolidation procedures employed at the end of the second and subsequent years are basically the same as those used at the end of the first year.
Adjusted trial balance data of the individual companies are used as the starting point each time consolidated statements are prepared because no separate
books are kept for the consolidated entity. An additional check is needed in each period following acquisition to ensure that the beginning balance of
consolidated retained earnings shown in the completed worksheet equals the balance reported at the end of the prior period. In all other respects, the
consolidation entries and worksheet are comparable with those shown for the first year.
Parent Company Entries
Consolidation after two years of ownership is illustrated by continuing the example of Peerless Products and Special Foods. Peerless’s separate income from
its own operations for 20X2 is $160,000, and its dividends total $60,000. Special Foods reports net income of $75,000 in 20X2 and pays dividends of
$40,000. Equity-method entries recorded by Peerless in 20X2 follow:
(4)
Investment in Special Foods
60,000
Income from Special Foods
60,000
Record Peerless’s 80% share of Special Foods’ 20X2 income.
(5)
Cash
Investment in Special Foods
32,000
32,000
Record Peerless’s 80% share of Special Foods’ 20X2 dividend.
Peerless’s reported net income totals $220,000 ($160,000 from separate operations + $60,000 from Special Foods).
Consolidation Worksheet—Second Year of Ownership
In order to complete the worksheet, Peerless must calculate the worksheet consolidation entries using the following process. The book value of equity can be
analyzed and summarized as follows:
The book value calculations indicate that the balance in Peerless’s Investment in Special Foods account increases from $256,000 to $284,000 in 20X2. Recall
that the numbers in the shaded font from the book value calculations appear in the basic consolidation entry. This consolidation entry removes both the
investment income reflected in the parent’s income statement and any dividends declared by the subsidiary during the period:
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Because there is no differential in this example, the basic consolidation entry completely eliminates the balance in Peerless’s investment account on the
balance sheet as well as the Income from Special Foods account on the income statement.
In this example, Special Foods had accumulated depreciation on the acquisition date of $300,000. Thus, we repeat the same accumulated depreciation
consolidation entry this year (and every year as long as Special Foods owns the assets) that we used in the initial year.
After placement of the two consolidation entries in the consolidation worksheet, the worksheet is completed in the normal manner as shown in Figure 3–
4.
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F I G U R E 3 –4
December 31, 20X2, Equity-Method Worksheet for Consolidated Financial Statements, Second Year of Ownership; 80 percent Acquisition
at Book Value
COMBINED FINANCIAL STATEMENTS
L O 3 –6
Understand and explain the purpose of combined financial statements and how they differ from consolidated financial statements.
Financial statements are sometimes prepared for a group of companies when no one company in the group owns a majority of the common stock of any
other company in the group. Financial statements that include a group of related companies without including the parent company or other owner are
referred to as combined financial statements.
Combined financial statements are commonly prepared when an individual, rather than a corporation, owns or controls a number of companies and
wishes to include them all in a single set of financial statements. In some cases, a parent company may prepare financial statements that include only its
subsidiaries, not the parent. In other cases, a parent may prepare financial statements for its subsidiaries by operating group, with all the subsidiaries engaged
in a particular type of operation, or those located in a particular geographical region, reported together.
The procedures used to prepare combined financial statements are essentially the same as those used in preparing consolidated financial statements. All
intercompany receivables and payables, intercompany transactions, and unrealized intercompany profits and losses must be eliminated in the
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same manner as in the preparation of consolidated statements. Although no parent company is included in the reporting entity, any
intercompany ownership, and the associated portion of stockholders’ equity, must be eliminated in the same way as the parent’s investment in a subsidiary is
eliminated in preparing consolidated financial statements. The remaining stockholders’ equity of the companies in the reporting entity is divided into the
portions accruing to the controlling and noncontrolling interests.
SPECIAL-PURPOSE AND VARIABLE INTEREST ENTITIES
L O 3 –7
Understand and explain rules related to the consolidation of variable interest entities.
Although consolidation standards pertaining to related corporations have at times lacked clarity and needed updating, consolidation standards relating to
partnerships or other types of entities such as trusts have been virtually nonexistent. Even corporate consolidation standards have not been adequate in
situations in which other relationships such as guarantees and operating agreements overshadow the lack of a significant ownership element. As a result, we
can observe historical examples where companies such as Enron have taken advantage of the lack of standards to avoid reporting debt or losses by hiding
them in special entities that were not consolidated. Current standards, as discussed below, seek to capture the economic substance of the relationships and
use this economic relationship as a measure to provide some uniformity in the financial reporting for corporations having relationships with such entities.
ASC 810 establishes consolidation standards in terms of one company controlling another and sets majority voting interest as the usual condition leading
to consolidation. Similarly, ASC 810 requires consolidation for majority-owned subsidiaries. However, new types of relationships continue to evolve between
corporations and other entities that often are difficult to characterize in terms of voting, controlling, or ownership interests. Such entities often are structured
to provide financing and/or control through forms other than those used by traditional operating companies. Some entities have no governing boards, or they
may have boards or managers with only a limited ability to direct the entity’s activities. Such entities may be governed instead by their incorporation or
partnership documents, or by other agreements or documents. Some entities may have little equity investment, and the equity investors may have little or no
control over the entity. For these special types of entities, ASC 810 does not always provide a clear basis for consolidation.
These special types of entities have generally been referred to as special-purpose entities (SPEs). In general, SPEs are corporations, trusts, or
partnerships created for a single specified purpose. They usually have no substantive operations and are commonly used only for financing purposes. SPEs
have been used for several decades for asset securitization, risk sharing, and taking advantage of tax statutes. Prior to 2003, no comprehensive reporting
framework had been established for SPEs. Several different pronouncements from various bodies dealt with selected issues or types of SPEs, but the
guidance provided by these issuances was incomplete, vague, and not always correctly interpreted in practice.
Variable Interest Entities
In January 2003, the FASB issued guidance on variable interest entities (ASC 810) and updated this guidance later the same year. In October of 2016, the
FASB further updated guidance on variable interest entities (ASC 810). For clarification, the interpretation uses the term variable interest entities to
encompass SPEs and any other entities falling within its conditions.
A variable interest entity (VIE) is a legal structure used for business purposes, usually a corporation, trust, or partnership, that either (1) does not have
equity investors that have voting rights and share in all of the entity’s profits and losses or (2) has equity investors that do not provide sufficient financial
resources to support the entity’s activities. In a variable interest entity, specific agreements may limit the extent to which the equity investors,
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if any, share in the entity’s profits or losses, and the agreements may limit the control that equity investors have over the entity’s activities.
A corporation (or any other reporting entity) having an interest in a VIE cannot simply rely on its percentage stock ownership, if any, to determine
whether to consolidate the entity. The entity that must consolidate the VIE will be the single entity that is determined to be the primary beneficiary of the
VIE. This primary beneficiary will be determined by applying the guidance in ASC 810 which requires each party having a variable interest in the VIE to
assess whether the reporting entity has a controlling financial interest in the VIE and, thus, is the VIE’s primary beneficiary.
The requirements of ASC 810 include an assessment of the characteristics of the corporation’s variable interests and other involvements (including
involvement of related parties and de facto agents), if any, in the VIE, as well as the involvement of other variable interest holders. Additionally, the
assessment shall consider the VIE’s purpose and design, including the risks that the VIE was designed to create and pass through to its variable interest
holders.
Under ASC 810, a reporting entity shall be deemed to have a controlling financial interest in a VIE if it has both of the following characteristics:
a. The power to direct the activities of a VIE that most significantly impact the VIE’s economic performance
b. The obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to
receive benefits from the VIE that could potentially be significant to the VIE. The quantitative approach
described in the definitions of the terms expected losses, expected residual returns, and expected
variability is not required and shall not be the sole determinant as to whether a reporting entity has these
obligations or rights.
According to ASC 810, only one reporting entity, if any, is expected to be identified as the primary beneficiary of a VIE. Although more than one
reporting entity could have the characteristic in (b) as identified above, only one reporting entity, if any, will have the power to direct the activities of a VIE
that most significantly impact the VIE’s economic performance.
Examples of VIEs
A corporation might create (or sponsor) a typical variable interest entity for a particular purpose, such as purchasing the sponsoring company’s receivables
or leasing facilities to the sponsoring company. The sponsoring company may acquire little or no stock in the VIE. Instead, the sponsoring company may
enlist another party to purchase most or all of the common stock, thus directing the activities of the VIE that most significantly impact the VIE’s economic
performance. Additionally, the majority of the VIE’s capital, however, normally comes from borrowing. Because lenders may be reluctant to lend (at least at
reasonable interest rates) to an entity with only a small amount of equity, the sponsoring company often guarantees the VIE’s loans. Thus, the sponsoring
company may have little or no equity investment in the VIE, but the loan guarantees represent a type of interest in the VIE, thereby leaving the corporation
with the obligation to absorb losses that could potentially be significant to the VIE.
Some of the many different types of variable interests are summarized as follows:
Type of Interest
Variable Interest?
Common stock, with no special features or provisions
Yes
Common stock, with loss protection or other provisions
Maybe
Senior debt
Usually not
Subordinated debt
Yes
Loan or asset guarantees
Yes
Common stock that places the owners’ investment at risk is a variable interest. In some cases, common stock may have, by agreement, special
provisions that protect the investor against losses or provide a fixed return. These special types of shares may not involve significant risk on
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the part of the investor and might, depending on the provisions, result in an interest that is not a variable interest. Senior debt usually carries a
fixed return and is protected against loss by subordinated interests. Subordinated debt represents a variable interest because if the entity’s cash flows are
insufficient to pay off the subordinated debt, the holders of that debt will sustain losses. They do not have the same protection against loss that holders of the
senior debt have. Parties that guarantee the value of assets or liabilities can sustain losses if they are called on to make good on their guarantees and,
therefore, the guarantees represent variable interests.
STOP & THINK
The following “red flags” often indicate a variable interest:
Subordinated loans to a VIE.
Equity interests in a VIE (50 percent or less).
Guarantees to a VIE’s lenders or equity holders.
Guarantees of asset recovery values.
Written put options on a VIE’s assets held by a VIE or its lenders or equity holders.
Forward contracts on purchases and sales.
As an example of the financial reporting determinations of parties with an interest in a VIE, suppose that Young Company and Zebra Corporation, both
financially stable companies, create YZ Corporation to lease equipment to Young and other companies. Zebra purchases all of YZ’s common stock. Young
guarantees Zebra a 7 percent dividend on its stock, agrees to absorb all of YZ’s losses, and guarantees fixed-rate bank loans that are made to YZ. Young also
has the ability to direct the purchasing and leasing of equipment for YZ Corporation. All profits in excess of the 7 percent payout to Zebra are split evenly
between Young and Zebra.
In this case, the bank loans are not variable interests because they carry a fixed interest rate and are guaranteed by Young, a company capable of honoring
the guarantee. Common stock of a VIE is a variable interest if the investment is at risk. In this case, Zebra’s investment is not at risk, but it does share in the
profits of YZ, and the amount of profits is not fixed. Therefore, the common stock is a variable interest. However, Zebra will not consolidate YZ because
Zebra does not share in the losses, all of which Young will bear. Young will consolidate YZ because Young has the power to direct the purchasing and leasing
activities of YZ, and Young’s guarantees give Young the obligation to absorb losses that could potentially be significant to YZ.
FYI
The Walt Disney Company’s 2016 10-K reports the company is the primary beneficiary for the VIEs of
Disneyland Paris, Hong Kong Disneyland Resort, and Shanghai Disney Resort (collectively, International
Theme Parks). Disney follows ASC
International Theme Parks.
810
by fully consolidating the financial statements of these
If consolidation of a VIE is appropriate, the amounts to be consolidated with those of the primary beneficiary are based on fair values at the date the
enterprise first becomes the primary beneficiary. However, as with all other consolidated subsidiaries, assets and liabilities transferred to a VIE by its primary
beneficiary are valued at their book values, with no gain or loss recognized on the transfer. Subsequent to the initial determination of consolidation values, a
VIE is accounted for in consolidated financial statements in accordance with ASC 810 in the same manner as if it were consolidated based on voting
interests. Intercompany balances and transactions are eliminated so the resulting consolidated financial statements appear as if there were just a single entity.
These procedures are consistent with those used when consolidating parent and subsidiary corporations. Appendix 3A at the end of the chapter presents a
simple illustration of the consolidation of a VIE.
IFRS Differences in Determining Control of VIEs and SPEs
L O 3 –8
Understand and explain differences in consolidation rules under U.S. GAAP and IFRS.
Rules under International Financial Reporting Standards (IFRS) for consolidation are generally very similar to those under U.S. GAAP. For example, both
IFRS and U.S. GAAP use the notion of control to determine whether a reporting entity should consolidate another entity. However, there are differences as to
the definition of control. Figure 3–5 provides a summary of the main differences related to Control and VIEs in current standards.
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FIGURE 3–5
Relevant
guidance
Summary of Differences between IFRS and U.S. GAAP related to Control and VIEs
U.S. GAAP
IFRS
ASC 810
IFRS 10, 12
Consolidation There are two consolidation models. First,
The basis for consolidation focuses on
model(s)
entities are subjected to the variable
control, regardless of the form of the
interest entity (VIE) model. If the VIE
investee.
model is not applicable, then entities
An investor controls an investee when it is
are subjected to the voting interest
exposed to, or has rights to, variable
model.
returns from its involvement with the
Under the VIE model, a reporting entity has
investee and has the ability to affect
a controlling financial interest in a VIE
those returns through its power over the
if it has (a) the power to direct the
investee.
activities of the VIE that most
This notion of control requires that the
significantly affect the VIE’s economic
investor have all three of the following
performance and (b) the obligation to
characteristics:
absorb losses or the rights to receive
Power over the investee.
benefits that could be significant to the
Exposure (or rights) to variable returns from
VIE.
its involvement with the investee.
Under the voting interest model, a
The ability to exercise its power over the
controlling financial interest generally
investee to affect the amount of the
exists if a reporting entity has a
investor’s returns.
majority voting interest in another
entity. In certain circumstances, the
power to control may exist when one
entity holds less than a majority voting
interest (e.g., because of contractual
provisions or agreements with other
shareholders).
De facto
control
The concept of “de facto control” does not De facto control is acknowledged by the
exist. The concept of “effective
existence of situations in which a parent
control” exists in connection with
company may have control over another
contracts, as indicated in the previous
entity despite: (a) holding less than a 50
row.
percent voting interest and (b) lacking
legal and (or) contractual rights that
would permit the entity to control the
investee’s voting power or board.
For example, de facto control may exist in a
situation in which a major shareholder
holds a less than majority stake in an
entity, but the other ownership holdings
are widely dispersed. To determine if
control exists in this situation, all
relevant facts and circumstances, including
the ability of the other owners to vote in
a block, would need to be considered.
Potential
Under the VIE model, potential voting rights Potential voting rights are considered only if
voting rights
might enter into the determination of (a)
substantive; that is, they must give the
whether the entity is a VIE or (b) which
holder the ability to direct the relevant
party is the primary beneficiary of a
activities of an investee and the holder
VIE.
must have the ability to exercise those
rights. An investor with potential voting
rights might have power over an investee,
even if the rights are not currently
exercisable.
Source: U.S. GAAP VS. IFRS: Consolidations at-a-Glance, RSM US LLP, AUDIT, August 2014.
SUMMARY OF KEY CONCEPTS
Consolidated financial statements present the financial position and operating results of a parent and one or more subsidiaries as if they were actually a single
company. As a result, the consolidated financial statements portray a group of legally separate companies as a single economic entity. All indications of
intercorporate ownership and the effects of all intercompany transactions are excluded from the consolidated statements. The basic approach to the preparation of
consolidated financial statements is to combine the separate financial statements of the individual consolidating companies and then to eliminate or adjust those
items that would not appear, or that would appear differently, if the companies actually were one.
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Current consolidation standards require that the consolidated financial statements include all companies under common control unless control is questionable.
Consolidated financial statements are prepared primarily for those with a long-run interest in the parent company, especially the parent’s stockholders and long-term
creditors. While consolidated financial statements allow interested parties to view a group of related companies as a single economic entity, such statements have
some limitations. In particular, information about the characteristics and operations of the individual companies within the consolidated entity is lost in the process
of combining financial statements.
New types of business arrangements have proven troublesome in the past for financial reporting. In particular, special types of entities, called special-purpose
entities and variable interest entities, have been used to hide or transform various types of transactions, in addition to being used for many legitimate purposes
such as risk sharing. Often these entities were disclosed only through vague notes to the financial statements. Reporting standards now require that the party that
is the primary beneficiary of a variable interest entity consolidate that entity.
KEY TERMS
combined financial statements, 114
consolidated net income, 102
direct control, 98
effective control, 100
indirect control, 98
minority interest, 100
noncontrolling interest, 100
primary beneficiary, 116
special-purpose entities (SPEs), 115
variable interest entity (VIE), 115
Appendix 3A
Consolidation of Variable
Interest Entities
The standards for determining whether a party with an interest in a variable interest entity (VIE) should consolidate the VIE were discussed earlier in the chapter.
Once a party has determined that it must consolidate a VIE, the consolidation procedures are similar to those used when consolidating a subsidiary. As an
illustration, assume that Ignition Petroleum Company joins with Mammoth Financial Corporation to create a special corporation, Exploration Equipment Company,
that would lease equipment to Ignition and other companies. Ignition purchases 10 percent of Exploration’s stock for $1 million, and Mammoth purchases the other
90 percent for $9 million. Profits are to be split equally between the two owners, but Ignition is given the power to direct the leasing operations of Exploration and
also agrees to absorb the first $500,000 of annual losses. Immediately after incorporation, Exploration borrows $120 million from a syndicate of banks, and Ignition
guarantees the loan. Exploration then purchases plant, equipment, and supplies for its own use and equipment for lease to others. The balance sheets of Ignition
and Exploration appear as follows just prior to the start of Exploration’s operations:
Item
Ignition
Cash and Receivables
Exploration
$100,000,000
23,500,000
50,000,000
200,000
Inventory and Supplies
Equipment Held for Lease
105,000,000
Investment in Exploration Equipment Co.
1,000,000
Plant & Equipment (net)
80,000,000
1,350,000
Total Assets
$331,000,000
$130,050,000
Accounts Payable
$
$
900,000
Bank Loans Payable
50,000
30,000,000
120,000,000
Common Stock Issued & Outstanding
200,000,000
10,000,000
Retained Earnings
100,100,000
Total Liabilities & Stockholders’ Equity
$331,000,000
$130,050,000
The above balance sheets for Ignition and Exploration can be consolidated using the normal approach. Since this consolidation is prior to the start of
operations, only the basic consolidation entry would be required as shown below. Note that even though Mammoth owns 90 percent of the common stock of
Exploration, since Ignition is the primary beneficiary of the VIE, Mammoth’s investment would be shown as a noncontrolling interest in the
page 120
consolidated financial statements. The basic consolidation entry and the consolidated balance sheet are shown below.
FIGURE 3–6
Balance Sheet Consolidating a Variable Interest Entity
IGNITION PETROLEUM COMPANY
Consolidated Balance Sheet
Assets
Cash & Receivables
$123,500,000
Inventory & Supplies
50,200,000
Equipment Held for Lease
105,000,000
Plant & Equipment (net)
181,350,000
Total Assets
$460,050,000
Liabilities
Accounts Payable
Bank Loans Payable
$
950,000
150,000,000
Total Liabilities
$150,950,000
Stockholders’ Equity
Common Stock
Retained Earnings
Noncontrolling Interest
Total Stockholders’ Equity
Total Liabilities & Stockholders’ Equity
$200,000,000
100,100,000
9,000,000
309,100,000
$460,050,000
Both Ignition and Mammoth hold variable interests in Exploration. Ignition’s variable interests include both its common stock and its guarantees. Ignition is the
primary beneficiary of Exploration because it has the power to direct the leasing operations of Exploration. Additional factors include that Ignition shares equally in
the profits with Mammoth, and Ignition is also is obligated to absorb losses of Exploration that could potentially be significant to Exploration. Accordingly, Ignition
must consolidate Exploration.
Ignition’s consolidated balance sheet that includes Exploration appears as in Figure 3–6. The balances in Exploration’s asset and liability accounts are added to
the balances of Ignition’s like accounts. Ignition’s $1 million investment in Exploration is eliminated against the common stock of Exploration, and Exploration’s
remaining $9 million of common stock (owned by Mammoth) is labeled as noncontrolling interest and reported within the equity section of the consolidated balance
sheet.
QUESTIONS
Q3–1
What is the basic idea underlying the preparation of consolidated financial statements?
LO 3–1
Q3–2
How might consolidated statements help an investor assess the desirability of purchasing shares
of the parent company?
LO 3–1
Q3–3
Are consolidated financial statements likely to be more useful to the owners of the parent
company or to the noncontrolling owners of the subsidiaries? Why?
LO 3–1
Q3–4
What is meant by parent company? When is a company considered to be a parent?
LO 3–2
Q3–5
Are consolidated financial statements likely to be more useful to the creditors of the parent
company or the creditors of the subsidiaries? Why?
LO 3–1
Q3–6
Why is ownership of a majority of the common stock of another company considered important
in consolidation?
LO 3–2
Q3–7
What major criteria must be met before a company is consolidated?
LO 3–2
page 121
Q3–8
When is consolidation considered inappropriate even though the parent holds a majority of the
voting common shares of another company?
LO 3–2
Q3–9
How has reliance on legal control as a consolidation criterion led to off-balance-sheet
financing?
LO 3–7
Q3–10
What types of entities are referred to as special-purpose entities, and how have they generally
been used?
LO 3–7
Q3–11
How does a variable interest entity typically differ from a traditional corporate business entity?
LO 3–7
Q3–12
What characteristics are normally examined in determining whether a company is a primary
beneficiary of a variable interest entity?
LO 3–7
Q3–13
What is meant by indirect control? Give an illustration.
LO 3–2
Q3–14
What means other than majority ownership might be used to gain control over a company? Can
consolidation occur if control is gained by other means?
LO 3–2
Q3–15
Why are subsidiary shares not reported as stock outstanding in the consolidated balance sheet?
LO 3–4
Q3–16
What must be done if the fiscal periods of the parent and its subsidiary are not the same?
LO 3–2
Q3–17
What is the noncontrolling interest in a subsidiary?
LO 3–3
Q3–18
What is the difference between consolidated and combined financial statements?
LO 3–4, 3–6
CASES
C3–1
Computation of Total Asset Values
LO 3–5
A reader of Gigantic Company’s consolidated financial statements received from another source copies of the financial statements of the individual companies
included in the consolidation. The person is confused by the fact that the total assets in the consolidated balance sheet differ rather substantially from the sum of
the asset totals reported by the individual companies.
Required
Will this relationship always be true? What factors may cause this difference to occur?
C3–2
Accounting Entity [AICPA Adapted]
LO 3–3, 3–7
The concept of the accounting entity often is considered to be the most fundamental of accounting concepts, one that pervades all of accounting. For each of the
following, indicate whether the entity concept is applicable; discuss and give illustrations.
Required
a.
A unit created by or under law.
b.
The product-line segment of an enterprise.
c.
A combination of legal units.
d.
All the activities of an owner or a group of owners.
e.
The economy of the United States.
C3–3
What Company Is That?
LO 3–1
Analysis
Many well-known products and names come from companies that may be less well known or may be known for other reasons. In some cases, an obscure parent
company may have well-known subsidiaries, and often familiar but diverse products may be produced under common ownership.
Required
a.
Viacom is not necessarily a common name easily identified because it operates through numerous subsidiaries, but its brand names are seen every day. What are
some of the well-known brand names from Viacom’s subsidiaries? How are National Amusements and Sumner Redstone related to Viacom?
b.
ConAgra Foods Inc. is one of the world’s largest food processors and distributors. Although it produces many products with familiar names, the company’s name
generally is not well known. What are some of ConAgra’s brand names?
c.
What type of company is Yum! Brands Inc.? What are some of its well-known brands? What is the origin of the company, and what was its previous
name?
C3–4
page 122
Subsidiaries and Core Businesses
LO 3–1
Analysis
During previous merger booms, a number of companies acquired many subsidiaries that often were in businesses unrelated to the acquiring company’s central
operations. In many cases, the acquiring company’s management was unable to manage effectively the many diverse types of operations found in the numerous
subsidiaries. More recently, many of these subsidiaries have been sold or, in a few cases, liquidated so the parent companies could concentrate on their core
businesses.
Required
a.
In 1986, General Electric acquired nearly all of the common stock of the large brokerage firm Kidder, Peabody Inc. Unfortunately, the newly acquired subsidiary’s
performance was very poor. What ultimately happened to this General Electric subsidiary?
b.
What major business has Sears Holdings Corporation been in for many decades? What other businesses was it in during the 1980s and early 1990s? What were
some of its best-known subsidiaries during that time? Does Sears still own those subsidiaries? What additional acquisitions have occurred?
c.
PepsiCo is best known as a soft-drink company. What well-known subsidiaries did PepsiCo own during the mid-1990s? Does PepsiCo still own them?
d.
When a parent company and its subsidiaries are in businesses that are considerably different in nature, such as retailing and financial services, how meaningful
are their consolidated financial statements in your opinion? Explain. How might financial reporting be improved in such situations?
C3–5
Consolidation Differences among Major Companies
LO 3–6
Research
A variety of organizational structures are used by major companies, and different approaches to consolidation are sometimes found. Two large and familiar U.S.
corporations are Union Pacific and ExxonMobil.
Required
a.
Many large companies have tens or even hundreds of subsidiaries. List the significant subsidiaries of Union Pacific Corporation as reported in the company’s
2016 10-K filing.
b.
ExxonMobil Corporation is a major energy company. Does ExxonMobil consolidate all of its majority-owned subsidiaries? Explain. Does ExxonMobil consolidate
any entities in which it does not hold majority ownership? Explain. What methods does ExxonMobil use to account for investments in the common stock of
companies in which it holds less than majority ownership?
EXERCISES
E3–1
Multiple-Choice Questions on Consolidation Overview [AICPA Adapted]
LO 3–1, 3–2
Select the correct answer for each of the following questions.
1. When a parent-subsidiary relationship exists, consolidated financial statements are prepared in recognition of the accounting concept of
a. Reliability.
b. Materiality.
c. Legal entity.
d. Economic entity.
2. Consolidated financial statements are typically prepared when one company has a controlling interest in another unless
a. The subsidiary is a finance company.
b. The fiscal year-ends of the two companies are more than three months apart.
c. Circumstances prevent the exercise of control.
d. The two companies are in unrelated industries, such as real estate and manufacturing.
3. Penn Inc., a manufacturing company, owns 75 percent of the common stock of Sell Inc., an investment company. Sell owns 60 percent of the common page 123
stock of Vane Inc., an insurance company. In Penn’s consolidated financial statements, should Sell and Vane be consolidated or reported as equity
method investments (assuming there are no side agreements)?
a. Consolidation used for Sell and equity method used for Vane.
b. Consolidation used for both Sell and Vane.
c. Equity method used for Sell and consolidation used for Vane.
d. Equity method used for both Sell and Vane.
4. Which of the following is the best theoretical justification for consolidated financial statements?
a. In form, the companies are one entity; in substance, they are separate.
b. In form, the companies are separate; in substance, they are one entity.
c. In form and substance, the companies are one entity.
d. In form and substance, the companies are separate.
E3–2
Multiple-Choice Questions on Variable Interest Entities
LO 3–7
Select the correct answer for each of the following questions.
1. Special-purpose entities generally
a. Have a much larger portion of assets financed by equity shareholders than do companies such as General Motors.
b. Have relatively large amounts of preferred stock and convertible securities outstanding.
c. Have a much smaller portion of their assets financed by equity shareholders than do companies such as General Motors.
d. Pay out a relatively high percentage of their earnings as dividends to facilitate the sale of additional shares.
2. Variable interest entities may be established as
a. Corporations.
b. Trusts.
c. Partnerships.
d. All of the above.
3. An enterprise that will absorb a majority of a variable interest entity’s expected losses is called the
a. Primary beneficiary.
b. Qualified owner.
c. Major facilitator.
d. Critical management director.
4. In determining whether or not a variable interest entity is to be consolidated, the FASB focused on
a. Legal control.
b. Share of profits and obligation to absorb losses.
c. Frequency of intercompany transfers.
d. Proportionate size of the two entities.
E3–3
Multiple-Choice Questions on Consolidated Balances [AICPA Adapted]
LO 3–5
Select the correct answer for each of the following questions.
Items 1 and 2 are based on the following:
On January 2, 20X8, Paint Company acquired 75 percent of Stain Company’s outstanding common stock at an amount equal to its underlying book value.
Selected balance sheet data at December 31, 20X8, follow:
page 124
Paint Company
Stain Company
Total Assets
$420,000
$180,000
Liabilities
$120,000
$
Common Stock
100,000
Retained Earnings
200,000
$420,000
60,000
50,000
70,000
$180,000
1. In Paint’s December 31, 20X8, consolidated balance sheet, what amount should be reported as noncontrolling interest in net assets?
a. $0
b. $30,000
c. $45,000
d. $105,000
2. In its consolidated balance sheet at December 31, 20X8, what amount should Paint report as common stock outstanding?
a. $50,000
b. $100,000
c. $137,500
d. $150,000
3. Consolidated statements are proper for Neely Inc., Randle Inc., and Walker Inc., if
a. Neely owns 80 percent of the outstanding common stock of Randle and 40 percent of Walker; Randle owns 30 percent of Walker.
b. Neely owns 100 percent of the outstanding common stock of Randle and 90 percent of Walker; Neely bought the Walker stock one month before the
foreign country in which Walker is based imposed restrictions preventing Walker from remitting profits to Neely.
c. Neely owns 100 percent of the outstanding common stock of Randle and Walker; Walker is in legal reorganization.
d. Neely owns 80 percent of the outstanding common stock of Randle and 40 percent of Walker; Reeves Inc. owns 55 percent of Walker.
E3–4
Multiple-Choice Questions on Consolidation Overview [AICPA Adapted]
LO 3–2, 3–3
Select the correct answer for each of the following questions.
1. Consolidated financial statements are typically prepared when one company has
a. Accounted for its investment in another company by the equity method.
b. Accounted for its investment in another company by the cost method.
c. Significant influence over the operating and financial policies of another company.
d. The controlling financial interest in another company.
2. Aaron Inc. owns 80 percent of the outstanding stock of Belle Inc. Compare the total consolidated net earnings of Aaron and Belle (X) and Aaron’s operating
earnings before considering the income from Belle (Y). Assume that neither company incurs a net loss during the period.
a. X is more than Y.
b. X is equal to Y.
c. X is less than Y.
d. The relative values of X and Y cannot be determined.
3. On October 1, X Company acquired for cash all of Y Company’s outstanding common stock. Both companies have a December 31 year-end and have been in
business for many years. Consolidated net income for the year ended December 31 should include net income of
a. X Company for 3 months and Y Company for 3 months.
b. X Company for 12 months and Y Company for 3 months.
c. X Company for 12 months and Y Company for 12 months.
page 125
d. X Company for 12 months, but no income from Y Company until Y Company distributes a dividend.
4. Ownership of 51 percent of the outstanding voting stock of a company would usually result in
a. The use of the cost method.
b. The use of the lower-of-cost-or-market method.
c. The use of the equity method.
d. A consolidation.
E3–5
Balance Sheet Consolidation
LO 3–5
On January 1, 20X3, Parade Corporation reported total assets of $470,000, liabilities of $270,000, and stockholders’ equity of $200,000. At that date, Summer
Corporation reported total assets of $190,000, liabilities of $135,000, and stockholders’ equity of $55,000. Following lengthy negotiations, Parade paid Summer’s
existing shareholders $44,000 in cash for 80 percent of the voting common shares of Summer.
Required
Immediately after Parade purchased the Summer shares,
a. What amount of total assets did Parade report in its individual balance sheet?
b. What amount of total assets was reported in the consolidated balance sheet?
c. What amount of total liabilities was reported in the consolidated balance sheet?
d. What amount of stockholders’ equity was reported in the consolidated balance sheet?
E3–6
Balance Sheet Consolidation with Intercompany Transfer
LO 3–5
Pawn Company acquired 90 percent of the voting common shares of Shop Corporation by issuing bonds with a par value and fair value of $121,500 to Shop’s
existing shareholders. Immediately prior to the acquisition, Pawn reported total assets of $510,000, liabilities of $320,000, and stockholders’ equity of $190,000. At
that date, Shop reported total assets of $350,000, liabilities of $215,000, and stockholders’ equity of $135,000.
Required
Immediately after Pawn acquired Shop’s shares,
a. What amount of total assets did Pawn report in its individual balance sheet?
b. What amount of total assets was reported in the consolidated balance sheet?
c. What amount of total liabilities was reported in the consolidated balance sheet?
d. What amount of stockholders’ equity was reported in the consolidated balance sheet?
E3–7
Subsidiary Acquired for Cash
LO 3–5
Pencil Company acquired 80 percent of Stylus Corporation’s stock on January 2, 20X3, for $72,000 cash. Summarized balance sheet data for the companies on
December 31, 20X2, follow:
Required
Prepare a consolidated balance sheet immediately following the acquisition.
page 126
E3–8
Subsidiary Acquired with Bonds
LO 3–5
Peace Computer Corporation acquired 75 percent of Symbol Software Company’s stock on January 2, 20X3, by issuing bonds with a par value of $50,000 and a fair
value of $67,500 in exchange for the shares. Summarized balance sheet data presented for the companies just before the acquisition follow:
Required
Prepare a consolidated balance sheet immediately following the acquisition.
E3–9
Subsidiary Acquired by Issuing Preferred Stock
LO 3–5
Peace Computer Corporation acquired 90 percent of Symbol Software Company’s common stock on January 2, 20X3, by issuing preferred stock with a par value of
$6 per share and a market value of $8.10 per share. A total of 10,000 shares of preferred stock was issued. Balance sheet data for the two companies immediately
before the business combination are presented in E3-8.
Required
Prepare a consolidated balance sheet for the companies immediately after Peace obtains ownership of Symbol by issuing the preferred stock.
E3–10
Reporting for a Variable Interest Entity
LO 3–4, 3–7
Gamble Company convinced Conservative Corporation that the two companies should establish Simpletown Corporation to build a new gambling casino in
Simpletown Corner. Although chances for the casino’s success were relatively low, a local bank loaned $140 million to the new corporation, which built the casino at
a cost of $130 million. Conservative purchased 100 percent of the initial capital stock offering for $5.6 million, and Gamble agreed to supply 100 percent of the
management which would include directing Simpletown’s day-to-day activities. Gamble also agreed to guarantee the bank loan. Additionally, Gamble guaranteed a
20 percent return to Conservative on its investment for the first 10 years. Gamble will receive all profits in excess of the 20 percent return to Conservative.
Immediately after the casino’s construction, Gamble reported the following amounts:
Cash
Buildings & Equipment
Accumulated Depreciation
Accounts Payable
$
3,000,000
240,600,000
10,100,000
5,000,000
Bonds Payable
20,300,000
Common Stock
103,000,000
Retained Earnings
105,200,000
The only disclosure that Gamble currently provides in its financial reports about its relationships to Conservative and Simpletown is a brief footnote indicating that
a contingent liability exists on its guarantee of Simpletown Corporation’s debt.
Required
Prepare a consolidated balance sheet in good form for Gamble immediately following the casino’s construction.
page 127
E3–11
Consolidation of a Variable Interest Entity
LO 3–4, 3–7
Teal Corporation is the primary beneficiary of a variable interest entity with total assets of $500,000, liabilities of $470,000, and owners’ equity of $30,000. Because
Teal owns 25 percent of the VIE’s voting stock, it reported a $7,500 investment in the VIE in its balance sheet. Teal reported total assets of $190,000 (including its
investment in the VIE), liabilities of $80,000, common stock of $15,000, and retained earnings of $95,000 in its balance sheet.
Required
Prepare a consolidated balance sheet in good form for Teal, assuming that it is the primary beneficiary of the variable interest entity.
E3–12
Computation of Subsidiary Net Income
LO 3–3
Pepper Corporation owns 70 percent of Salt Company’s stock. In the 20X9 consolidated income statement, the noncontrolling interest was assigned $18,000 of
income. There was no differential in the acquisition.
Required
What amount of net income did Salt Company report for 20X9?
E3–13
Incomplete Consolidation
LO 3–3, 3–4
Plug Motors’ accountant was called away after completing only half of the consolidated statements at the end of 20X4. The data left behind included the following:
Item
Plug Motors
Spark Body Shop
Cash
$ 40,000
$ 20,000
Accounts Receivable
180,000
30,000
200,000
Inventory
220,000
50,000
270,000
Buildings & Equipment (net)
300,000
290,000
590,000
Investment in Spark Body Shop
150,000
$ 1,120,000
Total Debits
$890,000
$390,000
Accounts Payable
$ 30,000
$ 40,000
Notes Payable
400,000
200,000
Common Stock
200,000
100,000
Retained Earnings
260,000
50,000
$890,000
$390,000
Total Credits
Consolidated
$
60,000
Required
a. Plug Motors acquired shares of Spark Body Shop at underlying book value on January 1, 20X1. What
portion of the ownership of Spark Body Shop does Plug apparently hold?
b. Compute the consolidated totals for each of the remaining balance sheet items.
E3–14
Noncontrolling Interest
LO 3–3, 3–4
Pesto Corporation acquired 70 percent of Sauce Corporation’s common stock on January 1, 20X7, for $294,000 in cash. At the acquisition date, the book values and
fair values of Sauce’s assets and liabilities were equal, and the fair value of the noncontrolling interest was equal to 30 percent of the total book value of Sauce. The
stockholders’ equity accounts of the two companies at the date of purchase are as follows:
Pesto
Corporation
Sauce
Corporation
$400,000
$180,000
Additional Paid-In Capital
222,000
65,000
Retained Earnings
358,000
175,000
$980,000
$420,000
Common Stock ($10 par value)
Total Stockholders’ Equity
Required
a. What amount will be assigned to the noncontrolling interest on January 1, 20X7, in the consolidated
balance sheet?
b. Prepare the stockholders’ equity section of Pesto and Sauce’s consolidated balance sheet as of
January 1, 20X7.
page 128
c. Pesto acquired ownership of Sauce to ensure a constant supply of electronic switches, which it purchases
regularly from Sauce. Why might Pesto not feel compelled to purchase all of Sauce’s shares?
E3–15
Computation of Consolidated Net Income
LO 3–3, 3–4
Phone Corporation owns 75 percent of Smart Company’s common stock, acquired at underlying book value on January 1, 20X4. At the acquisition date, the book
values and fair values of Smart’s assets and liabilities were equal, and the fair value of the noncontrolling interest was equal to 25 percent of the total book value of
Smart. The income statements for Phone and Smart for 20X4 include the following amounts:
Sales
Dividend Income
Phone
Corporation
Smart
Company
$528,000
$150,000
9,000
Total Income
$537,000
$150,000
Less: Cost of Goods Sold
$380,000
$ 87,000
32,000
20,000
Depreciation Expense
Other Expenses
66,000
23,000
Total Expenses
$478,000
$130,000
Net Income
$ 59,000
$ 20,000
Phone uses the cost method in accounting for its ownership of Smart. Smart paid dividends of $12,000 in 20X4.
Required
a. What amount would Phone report in its income statement as income from its investment in Smart if Phone
used equity-method accounting?
b. What amount of income should be assigned to noncontrolling interest in the consolidated income statement
for 20X4?
c. What amount should Phone report as consolidated net income for 20X4?
d. Why should Phone not report consolidated net income of $79,000 ($59,000 + $20,000) for 20X4?
E3–16
Computation of Subsidiary Balances
LO 3–4
Photo Corporation acquired 75 percent of Shutter Corporation’s voting common stock on January 1, 20X2, at underlying book value. At the acquisition date, the
book values and fair values of Shutter’s assets and liabilities were equal, and the fair value of the noncontrolling interest was equal to 25 percent of the total book
value of Shutter. Noncontrolling interest was assigned income of $8,000 in Photo’s consolidated income statement for 20X2 and a balance of $65,500 in Photo’s
consolidated balance sheet at December 31, 20X2. Shutter reported retained earnings of $70,000 and additional paid-in capital of $40,000 on January 1, 20X2. Shutter
did not pay dividends or issue stock in 20X2.
Required
a. Compute the amount of net income reported by Shutter for 20X2.
b. Prepare the stockholders’ equity section of Shutter’s balance sheet at December 31, 20X2.
E3–17
Subsidiary Acquired at Net Book Value
LO 3–4, 3–5
On December 31, 20X8, Paragraph Corporation acquired 80 percent of Sentence Company’s common stock for $136,000. At the acquisition date, the book values and
fair values of all of Sentence’s assets and liabilities were equal. Paragraph uses the equity method in accounting for its investment. Balance sheet information
provided by the companies at December 31, 20X8, immediately following the acquisition is as follows:
page 129
Paragraph
Corporation
Sentence
Company
$ 74,000
$ 20,000
Accounts Receivable
120,000
70,000
Inventory
180,000
90,000
Fixed Assets (net)
350,000
240,000
Investment in Sentence Company
136,000
Cash
Total Debits
$860,000
$420,000
Accounts Payable
$ 65,000
$ 30,000
Notes Payable
350,000
220,000
Common Stock
150,000
90,000
Retained Earnings
295,000
Total Credits
$860,000
80,000
$420,000
Required
Prepare a consolidated balance sheet for Paragraph at December 31, 20X8.
E3–18
Acquisition of Majority Ownership
LO 3–4
Stick Company reports net assets with a book value and fair value of $200,000. Paste Corporation acquires 75 percent ownership for $150,000. Paste reports net
assets with a book value of $520,000 and a fair value of $640,000 at that time, excluding its investment in Stick.
Required
For each of the following, compute the amounts that would be reported immediately after the combination under current accounting practice:
a. Consolidated net identifiable assets.
b. Noncontrolling interest.
PROBLEMS
P3–19
Multiple-Choice Questions
Statements [AICPA Adapted]
on
Consolidated
and
Combined
Financial
LO 3–4, 3–6
Select the correct answer for each of the following questions.
1. What is the theoretically preferred method of presenting a noncontrolling interest in a consolidated balance sheet?
a. As a separate item within the liability section.
b. As a deduction from (contra to) goodwill from consolidation, if any.
c. By means of notes or footnotes to the balance sheet.
d. As a separate item within the stockholders’ equity section.
2. Mr. Cord owns four corporations. Combined financial statements are being prepared for these corporations, which have intercompany loans of $200,000 and
intercompany profits of $500,000. What amount of these intercompany loans and profits should be included in the combined financial statements?
Intercompany
Loans
Profits
a. $200,000
$
b. $200,000
$500,000
c. $
0
$
d. $
0
$500,000
P3–20
0
0
Determining Net Income of Parent Company
LO 3–4
Potter Corporation and its subsidiary reported consolidated net income of $164,300 for 20X2. Potter owns 60 percent of the common shares of its subsidiary,
acquired at book value. Noncontrolling interest was assigned income of $15,200 in the consolidated income statement for 20X2.
page 130
Required
Determine the amount of separate operating income reported by Potter for 20X2.
P3–21
Consolidation of a Variable Interest Entity
LO 3–7
On December 28, 20X3, Stern Corporation and Ram Company established S&R Partnership, with cash contributions of $10,000 and $40,000, respectively. The
partnership’s purpose is to purchase from Stern accounts receivable that have an average collection period of 80 days and hold them to collection. The partnership
borrows cash from Midtown Bank and purchases the receivables without recourse but at an amount equal to the expected percent to be collected, less a financing
fee of 3 percent of the gross receivables. Stern and Ram hold 20 percent and 80 percent of the ownership of the partnership, respectively, and Stern guarantees both
the bank loan made to the partnership and a 15 percent annual return on the investment made by Ram. Stern receives any income in excess of the 15 percent return
guaranteed to Ram. The partnership agreement provides Stern total control over the partnership’s activities. On December 31, 20X3, Stern sold $8,000,000 of
accounts receivable to the partnership. The partnership immediately borrowed $7,500,000 from the bank and paid Stern $7,360,000. Prior to the sale, Stern had
established a $400,000 allowance for uncollectibles on the receivables sold to the partnership. The balance sheets of Stern and S&R immediately after the sale of
receivables to the partnership contained the following:
Stern Corporation
Cash
Accounts Receivable
Allowance for Uncollectible Accounts
Other Assets
Prepaid Finance Charges
Investment in S&R Partnership
Accounts Payable
$7,960,000
4,200,000
(210,000)
$
190,000
8,000,000
(400,000)
5,400,000
240,000
10,000
950,000
Deferred Revenue
240,000
Bank Notes Payable
Bonds Payable
S&R Partnership
7,500,000
9,800,000
Common Stock
700,000
Retained Earnings
6,150,000
Capital, Stern Corporation
10,000
Capital, Ram Company
40,000
Required
Assuming that Stern is S&R’s primary beneficiary, prepare a consolidated balance sheet in good form for Stern at January 1, 20X4.
P3–22
Reporting for Variable Interest Entities
LO 3–7
Purified Oil Company and Midwest Pipeline Corporation established Venture Company to conduct oil exploration activities in North America to reduce their
dependence on imported crude oil. Midwest Pipeline purchased all 20,000 shares of the newly created company for $10 each. Purified Oil agreed to purchase all of
Venture’s output at market price, guarantee up to $5 million of debt for Venture, and absorb all losses if the company proved unsuccessful. Purified and Midwest
agreed to share equally the profits up to $80,000 per year and to allocate 70 percent of those in excess of $80,000 to Purified and 30 percent to Midwest.
Venture immediately borrowed $3 million from Second National Bank and purchased land, drilling equipment, and supplies to start its operations. Following these
asset purchases, Venture and Purified Oil reported the following balances:
Venture Company
Purified Oil Company
$ 230,000
$ 410,000
Cash
Drilling Supplies
420,000
Accounts Receivable
Equipment (net)
640,000
1,800,000
6,700,000
Land
900,000
4,200,000
Accounts Payable
150,000
440,000
3,000,000
8,800,000
200,000
560,000
Bank Loans Payable
Common Stock
Retained Earnings
2,150,000
page 131
The only disclosure that Purified Oil currently provides in its financial statements with respect to its relationship with Midwest Pipeline and Venture is a brief note
indicating that a contingent liability exists on the guarantee of Venture Company debt.
Required
Assuming that Venture is considered to be a variable interest entity and Purified Oil is the primary beneficiary, prepare a balance sheet in good form for Purified Oil.
P3–23
Parent Company and Consolidated Amounts
LO 3–4
Pie Corporation acquired 80 percent of Slice Company’s common stock on December 31, 20X5, at underlying book value. The book values and fair values of Slice’s
assets and liabilities were equal, and the fair value of the noncontrolling interest was equal to 20 percent of the total book value of Slice. Slice provided the following
trial balance data at December 31, 20X5:
Debit
Cash
$ 28,000
Accounts Receivable
65,000
Inventory
90,000
Buildings & Equipment (net)
210,000
Cost of Goods Sold
105,000
Depreciation Expense
24,000
Other Operating Expenses
31,000
Dividends Declared
15,000
Accounts Payable
Credit
$ 33,000
Notes Payable
120,000
Common Stock
90,000
Retained Earnings
130,000
Sales
195,000
Total
$568,000
$568,000
Required
a.
How much did Pie pay to purchase its shares of Slice?
b.
If consolidated financial statements are prepared at December 31, 20X5, what amount will be assigned to the noncontrolling interest in the consolidated balance
sheet?
c.
If Pie reported income of $143,000 from its separate operations for 20X5, what amount of consolidated net income will be reported for 20X5?
d.
If Pie had purchased its ownership of Slice on January 1, 20X5, at underlying book value and Pie reported income of $143,000 from its separate operations for
20X5, what amount of consolidated net income would be reported for 20X5?
P3–24
Parent Company and Consolidated Balances
LO 3–4
Sheet Company reported the following net income and dividends for the years indicated:
Year
Net Income
Dividends
20X5
$35,000
$12,000
20X6
45,000
20,000
20X7
30,000
14,000
Pillow Corporation acquired 75 percent of Sheet’s common stock on January 1, 20X5. On that date, the fair value of Sheet’s net assets was equal to the book value.
Pillow uses the equity method in accounting for its ownership in Sheet and reported a balance of $259,800 in its investment account on December 31, 20X7.
Required
a.
What amount did Pillow pay when it purchased Sheet’s shares?
b.
What was the fair value of Sheet’s net assets on January 1, 20X5?
c.
What amount was assigned to the NCI shareholders on January 1, 20X5?
d.
What amount will be assigned to the NCI shareholders in the consolidated balance sheet prepared at December 31, 20X7?
page 132
P3–25
Indirect Ownership
LO 3–2, 3–4
Purple Corporation recently attempted to expand by acquiring ownership in Green Company. The following ownership structure was reported on December 31,
20X9:
Investor
Investee
Purple Corporation Green Company
Percentage of Ownership Held
70%
Green Company
Orange Corporation
10
Orange Corporation Blue Company
60
Green Company
40
Yellow Company
The following income from operations (excluding investment income) and dividend payments were reported by the companies during 20X9:
Company
Operating Income
Dividends Paid
$ 90,000
$ 60,000
Green Company
20,000
10,000
Orange Corporation
40,000
30,000
100,000
80,000
60,000
40,000
Purple Corporation
Blue Company
Yellow Company
Required
Compute the amount reported as consolidated net income for 20X9.
P3–26
Consolidated Worksheet
(Equity Method)
and
Balance
Sheet
on
the
Acquisition
Date
LO 3–4, 3–5
Peanut Company acquired 90 percent of Snoopy Company’s outstanding common stock for $270,000 on January 1, 20X8, when the book value of Snoopy’s net
assets was equal to $300,000. Peanut uses the equity method to account for investments. Trial balance data for Peanut and Snoopy as of January 1, 20X8, follow:
Peanut Company
Snoopy Company
Assets
Cash
Accounts Receivable
$
55,000
$
20,000
50,000
30,000
Inventory
100,000
60,000
Investment in Snoopy Company
270,000
Land
225,000
100,000
Buildings & Equipment
700,000
200,000
Accumulated Depreciation
(400,000)
Total Assets
(10,000)
$1,000,000
$400,000
75,000
25,000
Bonds Payable
200,000
75,000
Common Stock
500,000
200,000
Retained Earnings
225,000
100,000
$1,000,000
$400,000
Liabilities & Stockholders’ Equity
Accounts Payable
Total Liabilities & Equity
Required
a.
Prepare the journal entry on Peanut’s books for the acquisition of Snoopy on January 1, 20X8.
b.
Prepare a consolidation worksheet on the acquisition date, January 1, 20X8, in good form.
c.
Prepare a consolidated balance sheet on the acquisition date, January 1, 20X8, in good form.
page 133
P3–27
Consolidated Worksheet at End of the First Year of Ownership (Equity
Method)
LO 3–4, 3–5
Peanut Company acquired 90 percent of Snoopy Company’s outstanding common stock for $270,000 on January 1, 20X8, when the book value of Snoopy’s net
assets was equal to $300,000. Peanut uses the equity method to account for investments. Trial balance data for Peanut and Snoopy as of December 31, 20X8, follow:
Required
a.
Prepare any equity-method entry(ies) related to the investment in Snoopy Company during 20X8.
b.
Prepare a consolidation worksheet for 20X8 in good form.
P3–28
Consolidated Worksheet at End of the Second Year of Ownership (Equity
Method)
LO 3–4, 3–5
Peanut Company acquired 90 percent of Snoopy Company’s outstanding common stock for $270,000 on January 1, 20X8, when the book value of Snoopy’s net
assets was equal to $300,000. Problem 3–27 summarizes the first year of Peanut’s ownership of Snoopy. Peanut uses the equity method to account for investments.
The following trial balance summarizes the financial position and operations for Peanut and Snoopy as of December 31, 20X9:
page 134
Required
a.
Prepare any equity-method journal entry(ies) related to the investment in Snoopy Company during 20X9.
b.
Prepare a consolidation worksheet for 20X9 in good form.
P3–29
Consolidated Worksheet
(Equity Method)
and
Balance
Sheet
on
the
Acquisition
Date
LO 3–4, 3–5
Paper Company acquired 80 percent of Scissor Company’s outstanding common stock for $296,000 on January 1, 20X8, when the book value of Scissor’s net assets
was equal to $370,000. Paper uses the equity method to account for investments. Trial balance data for Paper and Scissor as of January 1, 20X8, follow:
Paper Company
Scissor Company
Assets
Cash
109,000
$ 25,000
65,000
37,000
Inventory
125,000
87,000
Investment in Scissor Company
296,000
Land
280,000
Accounts Receivable
$
125,000
Buildings & Equipment
875,000
250,000
Accumulated Depreciation
(500,000)
(24,000)
Total Assets
$1,250,000
$500,000
95,000
30,000
Bonds Payable
250,000
100,000
Common Stock
625,000
250,000
Liabilities & Stockholders’ Equity
Accounts Payable
Retained Earnings
Total Liabilities & Equity
280,000
$1,250,000
120,000
$500,000
Required
a.
Prepare the journal entry on Paper’s books for the acquisition of Scissor Co. on January 1, 20X8.
b.
Prepare a consolidation worksheet on the acquisition date, January 1, 20X8, in good form.
c.
Prepare a consolidated balance sheet on the acquisition date, January 1, 20X8, in good form.
P3–30
Consolidated Worksheet at End of the First Year of Ownership (Equity
Method)
LO 3–4, 3–5
Paper Company acquired 80 percent of Scissor Company’s outstanding common stock for $296,000 on January 1, 20X8, when the book value of Scissor’s net assets
was equal to $370,000. Paper uses the equity method to account for investments. Trial balance data for Paper and Scissor as of December 31, 20X8, are as follows:
page 135
Required
a.
Prepare any equity-method entry(ies) related to the investment in Scissor Company during 20X8.
b.
Prepare a consolidation worksheet for 20X8 in good form.
P3–31
Consolidated Worksheet at End of the Second Year of Ownership (Equity
Method)
LO 3–4, 3–5
Paper Company acquired 80 percent of Scissor Company’s outstanding common stock for $296,000 on January 1, 20X8, when the book value of Scissor’s net assets
was equal to $370,000. Problem 3–30 summarizes the first year of Paper’s ownership of Scissor. Paper uses the equity method to account for investments. The
following trial balance summarizes the financial position and operations for Paper and Scissor as of December 31, 20X9:
Required
a.
Prepare any equity-method journal entry(ies) related to the investment in Scissor Company during 20X9.
b.
Prepare a consolidation worksheet for 20X9 in good form.
1
Securities and Exchange Commission,
https://www.sec.gov/Archives/edgar/data/21344/000002134417000009/a20161213110k.htm
2
To view a video explanation of this topic, visit advancedstudyguide.com.
3
Although the term minority interest was commonly used in the past, ASC 805-10-20 replaces this term with
noncontrolling interest. The FASB’s intent is that the term noncontrolling interest be used going forward.
Thus, we use this term consistently throughout this and future chapters.
4
Note that the consolidated net income line properly adds Peerless’s reported net income, $180,000, to
Special Foods’ net income, $50,000, and eliminates Peerless’s share of Special Foods’ net income such that
the total consolidated net income is equal to Peerless’s income from separate operations ($140,000) plus
Special Foods’ reported net income ($50,000). On the other hand, the controlling interest in net income line
indicates that Peerless’s true income can be calculated in two ways. Either start with total consolidated
net income and deduct the portion that belongs to the NCI shareholders in the far right column or simply use
Peerless’s correctly calculated equity method net income, $180,000, which is its income from separate
operations ($140,000), plus its share of Special Foods’ net income ($40,000). The controlling interest in
the net Income line starts with this correctly calculated number from Peerless’s income statement (in the
first column) and adds it to Special Foods’ reported income (in the second column), but then eliminates
Special Foods’ reported income in the Consolidation Entries column. Thus, the controlling interest in net
income in the Consolidation column equals Peerless’s reported net income under the equity method.
page 136
4
Consolidation of Wholly Owned
Subsidiaries Acquired at More than
Book Value
Multicorporate Entities
Business Combinations
Consolidation Concepts and Procedures
Intercompany Transfers
Additional Consolidation Issues
Multinational Entities
Reporting Requirements
Partnerships
Governmental and Not-for-Profit Entities
Corporations in Financial Difficulty
HOW MUCH WORK DOES IT REALLY TAKE TO CONSOLIDATE? ASK THE PEOPLE WHO
DO IT AT DISNEY
The Walt Disney Company, started in California in 1923 as the Disney Brothers Cartoon Studio, is parent company to some of the most recognized
businesses in the world. While best known for Walt Disney Studios, international parks and resorts, media operations such as the Disney Channel, and its
consumer products, Disney is a widely diversified company. For example, did you know that Disney owns the ABC Television Network and is the majority
owner of ESPN?
Unlike the consolidation examples you’re working on in class that usually involve a parent company and a single subsidiary, Disney staff at its Burbank,
California, headquarters complete the consolidation of its five segments (each comprising many subsidiaries) each quarter in preparation for quarterly 10-Q
and annual 10-K SEC filings. Preparation for the consolidation begins before the end of the fiscal period when each segment closes its books (including
performing its own subsidiary consolidations), works with the independent auditors, and prepares for the overall company consolidation. Disney’s corporate
finance and accounting staff of more than 100 men and women review and analyze the results from the individual segments and work with segment financial
staff to prepare what becomes the publicly disclosed set of consolidated financial statements.
However, the work doesn’t all take place at the end of the fiscal period. Tracking all the many intercompany transactions involves ongoing coordinated
efforts. The consolidation process requires the elimination of intercompany sales and asset transfers among other cost allocations (as discussed in Chapters 6
and 7).
One of the reasons Disney has grown and become so diversified is that it frequently acquires other companies or portions of other companies. For
example, Disney recently bought a 33 percent stake in BAMTech, which holds Major League Baseball’s streaming technology and content delivery business,
for $1 billion. Terms of the agreement give Disney the right to increase ownership to 66 percent by buying more shares between 2020 and 2023. 1 For now,
Disney owns a minority stake in BAMTech and accounts for this investment using the equity method. However, if Disney elects to exercise the right to
increase ownership, this investment may need to be consolidated in the future.
Some of Disney’s other more notable acquisitions in recent years are Lucasfilm in 2012 (for $4.05 billion in cash and stock), Marvel Entertainment in
2009 (for $4 billion in cash and stock), and Pixar Animation Studios in 2006 (for $7.4 billion in stock). In these and other well-known acquisitions, Disney
paid more than the book value of each acquired company’s net assets. Acquisition accounting rules require Disney to account for the full
page 137
acquisition price, even though the acquired companies may continue to report their assets and liabilities on their separate books at their
historical book values. Thus, acquisition accounting requires Disney to essentially revalue the balance sheets of these companies to their amortized fair values
in the consolidation process each period. (We provide more details on the Pixar and Lucasfilm acquisitions later in the chapter.)
Preparation of Disney’s publicly disclosed financial statements is the culmination of a great deal of work by the segment and corporate accounting and
finance staff. The issues mentioned here illustrate the complexity of a process that requires substantial teamwork and effort to produce audited financial
statements valuable to an investor or an interested accounting student. You will learn in this chapter about the activities performed during the consolidation
process by the accounting staff of a public company. This chapter also introduces distinctions in the consolidation process when there is a differential (i.e.,
the acquiring company pays something other than the book value of the acquired company’s net assets).
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO 4–1
Understand and make equity-method journal entries related to the differential.
LO 4–2
Understand and explain how consolidation procedures differ when there is a differential.
LO 4–3
Make calculations and prepare consolidation entries for the consolidation of a wholly owned subsidiary when there is a complex positive
differential at the acquisition date.
LO 4–4
Make calculations and prepare consolidation entries for the consolidation of a wholly owned subsidiary when there is a complex bargainpurchase differential.
LO 4–5
Prepare equity-method journal entries, consolidation entries, and the consolidation worksheet for a wholly owned subsidiary when there is
a complex positive differential.
LO 4–6
Understand and explain the elimination of basic intercompany transactions.
LO 4–7
Understand and explain the basics of push-down accounting.
DEALING WITH THE DIFFERENTIAL
This chapter continues to build upon the foundation established in Chapters 2 and 3 related to the consolidation of majority-owned subsidiaries. In Chapters 2
and 3, we focus on relatively simple situations when the acquisition price is exactly equal to the parent’s share of the book value of the subsidiary’s net assets
or where the subsidiary is created by the parent. In Chapter 4, we relax this assumption and allow the acquisition price to differ from book value. As
explained in Chapter 1, this allows for a differential.
page 138
The Difference between Acquisition Price and Underlying Book Value
When an investor purchases the common stock of another company, the purchase price normally is based on the market value of the shares acquired rather
than the book value of the investee’s assets and liabilities. Not surprisingly, the acquisition price is usually different from the book value of the investor’s
proportionate share of the investee’s net assets. This difference is referred to as a differential. The differential is frequently positive, meaning the acquiring
company pays more than its share of the book value of the subsidiary’s net assets. Note that in the case of an equity-method investment, the differential on
the parent’s books relates only to the parent’s share of any difference between total investee’s fair value and book value. The differential in the case of an
equity-method investment is implicit in the investment account on the parent’s books and is not recorded separately.
FYI
For the five years ended June 30, 2016, Microsoft Corporation reported an increase in goodwill of $17.5
billion resulting from acquisitions.
The cost of an investment might exceed the book value of the underlying net assets, giving rise to a positive differential, for any of several reasons. One
reason is that the investee’s assets may be worth more than their book values. Another reason could be the existence of unrecorded goodwill associated with
the excess earning power of the investee. In either case, the portion of the differential pertaining to each asset of the investee, including goodwill, must be
ascertained. When the parent company uses the equity method, for reporting purposes (i.e., the subsidiary remains unconsolidated), that portion of the
differential pertaining to limited-life assets of the investee, including identifiable intangibles, must be amortized over the remaining economic lives of those
assets. Any portion of the differential that represents goodwill (referred to as equity-method goodwill or implicit goodwill) is not amortized or separately
tested for impairment. However, an impairment loss on the investment itself should be recognized if it suffers a material decline in value that is other than
temporary (ASC 323).
Amortization or Write-Off of the Differential 2
L O 4 –1
Understand and make equity-method journal entries related to the differential.
When the equity method is used, each portion of the differential must be treated in the same manner that the investee treats the assets or liabilities to which
the differential relates. Thus, any portion of the differential related to depreciable or amortizable assets of the investee should be amortized over the remaining
time to which the cost of the related asset is being allocated by the investee. Amortization of the differential associated with depreciable or amortizable assets
of the investee is necessary on the investor’s books to reflect the decline in the future benefits the investor expects from that portion of the investment cost
associated with those assets. The investee recognizes the reduction in service potential of assets with limited lives as depreciation or amortization expense
based on the amount it has invested in those assets. This reduction, in turn, is recognized by the investor through its share of the investee’s net income.
When the acquisition price of the investor’s interest in the investee’s assets is higher than the investee’s cost (as reflected in a positive differential), the
additional cost must be amortized.
The approach to amortizing the differential that is most consistent with the idea of reflecting all aspects of the investment in just one line on the balance
sheet and one line on the income statement is to reduce the income recognized by the investor from the investee and the balance of the investment account:
Income from Investee
Investment in Common Stock of Investee
XXX
XXX
page 139
The differential represents the amount paid by the investor company in excess of the book value of the net assets of the investee company and is included in
the original acquisition price. Hence, the amortization or reduction of the differential involves the reduction of the investment account. At the same time, the
investor’s net income must be reduced by an equal amount to recognize that a portion of the amount paid for the investment has expired.
Treatment of the Differential Illustrated
To illustrate how to apply the equity method when the cost of the investment exceeds the book value of the underlying net assets, assume that Ajax
Corporation purchases 40 percent of the common stock of Barclay Company on January 1, 20X1, for $200,000. Barclay has net assets on that date with a
book value of $400,000 and a fair value of $465,000. The total differential is equal to the market value of Barclay’s common stock, $500,000
($200,000/40%), minus the book value of its net assets, $400,000. Thus, the entire differential is $100,000.
Ajax’s share of the book value of Barclay’s net assets at acquisition is $160,000 ($400,000 × 0.40). Thus, Ajax’s 40 percent share of the differential is
computed as follows:
Cost of Ajax’s investment in Barclay’s stock
$200,000
Book value of Ajax’s share of Barclay’s net assets (160,000)
Ajax’s share of the differential
$ 40,000
The portion of the total differential that can be directly traced to specific assets that are undervalued on Barclay’s books is the $65,000 excess of the fair
value over the book value of Barclay’s net assets ($465,000 − $400,000) and the remaining $35,000 of the differential is goodwill. Specifically, an appraisal
of Barclay’s assets indicates that its land is worth $15,000 more than the recorded value on its books and its equipment is worth $50,000 more than its
current book value. Ajax’s 40 percent share of the differential is as follows:
Total Increase
Land
Ajax’s 40% Share
$ 15,000
6,000
Equipment
50,000
20,000
Goodwill
35,000
14,000
$100,000
$40,000
Thus, $26,000 of Ajax’s share of the differential is assigned to land and equipment, with the remaining $14,000 attributed to goodwill. The allocation of
Ajax’s share of the differential can be illustrated as shown in the diagram below:
Although the differential relates to Barclay’s assets, the additional cost incurred by Ajax to acquire a claim on Barclay’s assets is reflected in Ajax’s
investment in Barclay.There is no need to establish a separate differential account, and separate accounts are not recorded on Ajax’s books to
page 140
reflect the apportionment of the differential to specific assets. Similarly, a separate expense account is not established on Ajax’s books.
Amortization or write-off of the differential is accomplished by reducing Ajax’s investment account and the income Ajax recognizes from its investment in
Barclay.
Because land has an unlimited economic life, the portion of the differential related to land is not amortized. Ajax’s $20,000 portion of the differential
related to Barclay’s equipment is amortized over the equipment’s remaining life. If the equipment’s remaining life is five years, Ajax’s annual amortization of
the differential is $4,000 ($20,000 ÷ 5), assuming straight-line depreciation.
Regarding the goodwill in the differential, accounting standards state that equity-method goodwill is not amortized nor is it separately tested for
impairment when the equity method is used for reporting purposes. Instead, the entire investment is tested for impairment (ASC 323). In this example, the
only amortization of the differential is the $4,000 related to Barclay’s equipment.
Barclay reports net income of $80,000 at year-end and declares dividends of $20,000 during 20X1. Using the equity-method, Ajax records the following
entries on its books during 20X1:
(1)
Investment in Barclay Stock
200,000
Cash
200,000
Record purchase of Barclay Stock.
(2)
Investment in Barclay Stock
32,000
Income from Barclay Company
32,000
Record equity-method income: $80,000 × 0.40.
(3)
Cash
Investment in Barclay Stock
Record dividend from Barclay: $20,000 × 0.40.
8,000
8,000
(4)
Income from Barclay Company
4,000
Investment in Barclay Stock
4,000
Amortize differential related to equipment.
With these entries, Ajax recognizes $28,000 of income from Barclay and adjusts its investment in Barclay to an ending balance of $220,000.
The amortization on Ajax’s books of the portion of the differential related to Barclay’s equipment is the same ($4,000) for each of the first five years
(20X1 through 20X5). This amortization stops after 20X5 because this portion of the differential is fully amortized after five years.
Notice that special accounts are not established on Ajax’s books with regard to the differential or the amortization of the differential. The only two
accounts involved are Income from Barclay Company and Investment in Barclay Company Stock. As the Investment in Barclay Company Stock account is
amortized, the differential between the carrying amount of the investment and the book value of the underlying net assets decreases.
Disposal of Differential-Related Assets
Although the differential is included on the books of the investor as part of the investment account, it relates to specific assets of the investee. Thus, if the
investee disposes of any asset to which the differential relates, that portion of the differential must be removed from the investment account on the investor’s
books. When this is done, the investor’s share of the investee’s gain or loss on disposal of the asset must be adjusted to reflect the fact that the investor paid
more for its proportionate share of that asset than did the investee. For example, if in the previous illustration Barclay Company sells the land to page 141
which $6,000 of Ajax’s differential relates, Ajax does not recognize a full 40 percent of the gain or loss on the sale. Assume that Barclay originally
had purchased the land in 20X0 for $75,000 and sells the land in 20X2 for $125,000. Barclay recognizes a gain on the sale of $50,000, and Ajax’s share of
that gain is 40 percent, or $20,000. The portion of the gain actually recognized by Ajax, however, must be adjusted as follows because of the amount in
excess of book value paid by Ajax for its investment in Barclay:
Ajax’s share of Barclay’s reported gain
Portion of Ajax’s differential related to the land
Gain to be recognized by Ajax
$20,000
(6,000)
$14,000
Thus, if Barclay reports net income (including the gain on the sale of land) of $150,000 for 20X2, Ajax records the following entries (disregarding
dividends and amortization of the differential relating to equipment):
(5)
Investment in Barclay Company
60,000
Income from Barclay Company
60,000
Record equity-method income: $150,000 × 0.40.
(6)
Income from Barclay Company
Investment in Barclay Stock
6,000
6,000
Remove differential related to Barclay’s land that was sold.
The same approach applies when dealing with a limited-life asset. The unamortized portion of the original differential relating to the asset sold is removed
from the investment account, and the investor’s share of the investee’s income is adjusted by that amount.
Note that the investor does not separately report its share of ordinary gains or losses included in the investee’s net income, such as the gain on the sale of
the fixed asset or the write-off of the unamortized differential. Consistent with the idea of using only a single line in the income statement to report the impact
of the investee’s activities on the investor, all such items are included in the Income from Investee account. Current standards require the investor to report
its share of an investee’s extraordinary gains and losses, discontinued operations, and elements of other comprehensive income, if material to the investor, as
separate items in the same manner as the investor reports its own.
Impairment of Investment Value
As with many assets, accounting standards require that equity-method investments be written down if their value is impaired. If the market value of the
investment declines materially below its equity-method carrying amount, and the decline in value is considered other than temporary, the carrying amount of
the investment should be written down to the market value and a loss should be recognized. The new lower value serves as a starting point for continued
application of the equity-method. Subsequent recoveries in the value of the investment may not be recognized.
ADDITIONAL CONSIDERATIONS
Disney’s 2006 Pixar Acquisition
On May 5, 2006, Disney completed an all-stock acquisition of Pixar, a digital animation studio. To purchase Pixar, Disney exchanged 2.3 shares of its
common stock for each share of Pixar common stock, resulting in the issuance of 279 million shares of Disney common stock, and converted
previously issued vested andunvested Pixar equity-based awards into approximately 45 million Disney equity-based awards.
page 142
The acquisition purchase price was $7.5 billion ($6.4 billion, net of Pixar’s cash and investments of approximately $1.1 billion). The
value of the stock issued was calculated based on the market value of the Company’s common stock using the average stock price for the five-day
period beginning two days before the acquisition announcement date on January 24, 2006. The fair value of the vested equity-based awards issued at
the closing was estimated using the Black-Scholes option pricing model, as the information required to use a binomial valuation model was not
reasonably available.
The Company allocated the purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed based on their fair values,
which were determined primarily through third-party appraisals. The excess of the purchase price over those fair values was recorded as goodwill,
which is not amortizable for tax purposes. The fair values set forth below are subject to adjustment if additional information is obtained prior to the oneyear anniversary of the acquisition that would change the fair value allocation as of the acquisition date. The following table summarizes the allocation
of the purchase price:
Estimated
Fair Value
Cash and cash equivalents
Investments
$
Weighted Average
Useful Lives (years)
11
1,073
Prepaid and other assets
45
Film costs
538
12
Buildings & equipment
225
16
Intangibles
233
17
Goodwill
Total assets acquired
5,557
$ 7,682
Liabilities
64
Deferred income taxes
123
Total liabilities assumed
$
187
Net assets acquired
$ 7,495
Disney’s 2012 Lucasfilm Acquisition
On October 30, 2012, The Walt Disney Company announced the acquisition of Lucasfilm Ltd. in a stock and cash transaction. * The press release on
that date states:
“For the past 35 years, one of my greatest pleasures has been to see Star Wars passed from one
generation to the next,” said George Lucas, Chairman and Chief Executive Officer of Lucasfilm. “It’s
now time for me to pass Star Wars on to a new generation of filmmakers. I’ve always believed that Star
Wars could live beyond me, and I thought it was important to set up the transition during my lifetime. . . .
Disney’s reach and experience give Lucasfilm the opportunity to blaze new trails in film, television,
interactive media, theme parks, live entertainment, and consumer products.”
The acquisition combines two highly compatible family entertainment brands and strengthens the
long-standing beneficial relationship between them that already includes successful integration of Star
Wars content into Disney theme parks in Anaheim, Orlando, Paris, and Tokyo. Driven by a tremendously
talented creative team, Lucasfilm’s legendary Star Wars franchise has flourished for
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more than 35 years and offers a virtually limitless universe of characters and stories to
drive continued feature film releases and franchise growth over the long term. Star Wars resonates with
consumers around the world and creates extensive opportunities for Disney to deliver the content across
its diverse portfolio of businesses including movies, television, consumer products, games, and theme
parks. Star Wars feature films have earned a total of $4.4 billion in global box office ticket sales to
date. Continued global demand has made Star Wars one of the world’s top product brands, and
Lucasfilm a leading product licensor in the United States in 2011. . . . The Lucasfilm acquisition
follows Disney’s very successful acquisitions of Pixar and Marvel, which demonstrated the company’s
unique ability to fully develop and expand the financial potential of high quality creative content with
compelling characters and storytelling through the application of innovative technology and
multiplatform distribution on a truly global basis to create maximum value. Adding Lucasfilm to
Disney’s portfolio of world class brands significantly enhances the company’s ability to serve
consumers with a broad variety of the world’s highest-quality content and to create additional long-term
value for our shareholders.
On December 21, 2012, the Walt Disney Company completed the merger transaction in which the company distributed 37.1 million shares and paid
$2.2 billion in cash. Based on the $50 per share closing price of Disney shares on December 21, 2012, the transaction had a value of $4.1 billion. The
excess of the purchase price over those fair values of assets was allocated to goodwill.
CONSOLIDATION PROCEDURES FOR WHOLLY OWNED SUBSIDIARIES ACQUIRED AT
MORE THAN BOOK VALUE
L O 4 –2
Understand and explain how consolidation procedures differ when there is a differential.
Many factors have an effect on the fair value of a company and its stock price, including its asset values, its earning power, and general market conditions.
When one company acquires another, the acquiree’s fair value usually differs from its book value (differential), and so the consideration given by the acquirer
does as well.
The process of preparing a consolidated balance sheet immediately after a business combination is complicated only slightly when 100 percent of a
company’s stock is acquired at a price that differs from the acquiree’s book value. To illustrate the acquisition of a subsidiary when the consideration given is
greater than the book value of the net assets of the acquiree, we use the Peerless-Special Foods example from Chapter 2. We assume that Peerless Products
acquires all of Special Foods’ outstanding stock on January 1, 20X1, by paying $340,000 cash, an amount equal to Special Foods’ fair value as a whole. The
consideration given by Peerless is $40,000 in excess of Special Foods’ book value of $300,000. The resulting ownership situation can be viewed as follows:
Peerless records the stock acquisition with the following entry:
(7)
Investment in Special Foods
Cash
340,000
340,000
Record purchase of Special Foods stock.
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In a business combination, and therefore in a consolidation following a business combination, the full amount of the consideration given by the acquirer
must be assigned to the individual assets and liabilities acquired and to goodwill. In this example, the fair value of consideration given (the acquisition price)
includes an extra $40,000 for appreciation in the value of the land since it was originally acquired by Special Foods. The relationship between the fair value of
the consideration given for Special Foods, the fair value of Special Foods’ net assets, and the book value of Special Foods’ net assets can be illustrated as
follows:
Assume that Peerless prepares a consolidated balance sheet on the date it acquires Special Foods. The consolidation worksheet procedures used in
adjusting to the proper consolidated amounts follow a consistent pattern. The first worksheet entry (often referred to as the “basic” consolidation entry)
eliminates the book value portion of the parent’s investment account and each of the subsidiary’s stockholder equity accounts. It is useful to analyze the
investment account and the subsidiary’s equity accounts as follows:
The worksheet entry to eliminate the book value portion of Peerless’s investment account and the stockholders’ equity accounts of Special Foods is as
follows:
When the acquisition-date fair value of the consideration is more than the acquiree’s book value at that date, the second consolidation entry reclassifies
the excess acquisition price to the specific accounts on the balance sheet for which the book values are not the same as their fair values on the acquisition
date. 3 The differential represents (in simple situations involving a 100 percent acquisition) the total difference between the acquisition-date fair value of the
consideration given by the acquirer and the acquiree’s book value of net assets. In this example, the differential is the additional $40,000
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Peerless paid to acquire Special Foods because its land was worth $40,000 more than its book value as of the acquisition date. In preparing a
consolidated balance sheet immediately after acquisition (on January 1, 20X1), the second consolidation entry appearing in the consolidation worksheet
simply reassigns this $40,000 from the investment account to the land account so that: (a) the land account fully reflects the fair value of this asset as of the
acquisition date, and (b) the investment account is fully eliminated from Peerless’s books:
Thus, these two consolidation entries completely eliminate the balance in Peerless’s investment account and the second entry assigns the differential to
the land account.
In more complicated examples when the fair values of various balance sheet accounts differ from book values, the excess value reclassification entry
reassigns the differential to adjust various account balances to reflect the fair values of the subsidiary’s assets and liabilities at the time the parent acquired the
subsidiary and to establish goodwill, if appropriate.
Figure 4–1 illustrates the consolidation worksheet reflecting the elimination of Special Foods’ equity accounts and the allocation of the differential to the
subsidiary’s land. As explained previously, the combination of these two worksheet entries also eliminates the investment account.
F I G U R E 4 –1
January 1, 20X1, Worksheet for Consolidated Balance Sheet, Date of Combination; 100 Percent Acquisition at More than Book Value
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As usual, we eliminate Special Foods’ acquisition date accumulated depreciation against the Buildings and Equipment account balance so that, combined
with the excess value reclassification entry, it will appear as if these fixed assets were recorded at their acquisition costs.
The amounts reported externally in the consolidated balance sheet are those in the Consolidated column of the worksheet in Figure 4–1. Land would be
included in the consolidated balance sheet at $255,000, the amount carried on Peerless’s books ($175,000), plus the amount carried on Special Foods’ books
($40,000), plus the differential reflecting the increased value of Special Foods’ land ($40,000).
This example is simple enough that the assignment of the differential to land could be made directly in the basic consolidation entry rather than through
the use of a separate entry. In practice, however, the differential often relates to more than a single asset, and the allocation of the differential may be
considerably more complex than in this example. The possibilities for clerical errors are reduced in complex situations by making two separate entries rather
than one complicated entry.
Treatment of a Positive Differential
The fair value, and hence acquisition price, of a subsidiary might exceed the book value for several reasons, such as the following:
1. Errors or omissions on the subsidiary’s books.
2. Excess of fair value over the book value of the subsidiary’s net identifiable assets.
3. Existence of goodwill.
Errors or Omissions on the Books of the Subsidiary
An examination of an acquired company’s books may reveal material errors. In some cases, the acquired company may have expensed rather than capitalized
assets or, for other reasons, omitted them from the books. An acquired company that previously had been closely held may not have followed generally
accepted accounting principles in maintaining its accounting records. In some cases, the recordkeeping may have simply been inadequate.
Where errors or omissions occur, corrections should be made directly on the subsidiary’s books as of the date of acquisition. These corrections are
treated as prior-period adjustments in accordance with ASC 250. Once the subsidiary’s books are stated in accordance with generally accepted accounting
principles, that portion of the differential attributable to errors or omissions will no longer exist.
Excess of Fair Value over Book Value of Subsidiary’s Net Identifiable Assets
The fair value of a company’s assets is an important factor in the overall determination of the company’s fair value. In many cases, the fair value of an
acquired company’s net assets exceeds the book value. Consequently, the consideration given by an acquirer may exceed the acquiree’s book value. The
procedures used in preparing the consolidated balance sheet should lead to reporting all of the acquired company’s assets and liabilities based on their fair
values on the date of combination. This valuation may be accomplished in one of two ways: (1) the subsidiary’s assets and liabilities may be revalued directly
on the books of the subsidiary or (2) the accounting basis of the subsidiary may be maintained and the revaluations made each period in the consolidation
worksheet.
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Revaluing the assets and liabilities on the subsidiary’s books generally is the simplest approach if all of the subsidiary’s common stock is acquired. On the
other hand, it generally is not appropriate to revalue the assets and liabilities on the subsidiary’s books if there is a significant noncontrolling interest in that
subsidiary. From a noncontrolling shareholder’s point of view, the subsidiary is a continuing company, and the basis of accounting should not change. More
difficult to resolve is the situation in which the parent acquires all of the subsidiary’s common stock but continues to issue separate financial statements of
the subsidiary to holders of the subsidiary’s bonds or preferred stock. Revaluing the assets and liabilities of the subsidiary directly on its books is referred to
as push-down accounting. It is discussed later in this chapter and is illustrated in Appendix 4A.
When the assets and liabilities are revalued directly on the subsidiary’s books, then that portion of the differential no longer exists. However, if the assets
and liabilities are not revalued on the subsidiary’s books, an entry to revalue those assets and allocate the differential is needed in the consolidation worksheet
each time consolidated financial statements are prepared for as long as the related assets are held.
Existence of Goodwill
If the acquisition-date fair value of the consideration exchanged for an acquired subsidiary is higher than the total fair value of the subsidiary’s net identifiable
assets, the difference is considered to be related to the future economic benefits associated with other assets of the subsidiary that are not separately
identified and recognized and is referred to as goodwill. Thus, once a subsidiary’s identifiable assets and liabilities are revalued to their fair values, any
remaining debit differential is normally allocated to goodwill. For example, assuming that in the Peerless Products and Special Foods illustration, the
acquisition-date fair values of Special Foods’ assets and liabilities are equal to their book values, then the $40,000 difference between the $340,000
consideration exchanged and the $300,000 fair value of the subsidiary’s net identifiable assets should be attributed to goodwill. The following entry to assign
the differential is needed in the consolidation worksheet prepared immediately after the combination:
The consolidation worksheet is similar to Figure 4–1 except that the debit in the excess value reclassification worksheet entry would be to goodwill instead of
land. Goodwill, which does not appear on the books of either Peerless or Special Foods, would appear at $40,000 in the consolidated balance sheet prepared
immediately after acquisition.
In the past, some companies have included the fair-value increment related to certain identifiable assets of the subsidiary in goodwill rather than separately
recognizing those assets. This treatment is not acceptable, and any fair-value increment related to an intangible asset that arises from a contractual or legal
right or that is separable from the entity must be allocated to that asset.
Illustration of Treatment of a Complex Differential
L O 4 –3
Make calculations and prepare consolidation entries for the consolidation of a wholly owned subsidiary when there is a complex positive
differential at the acquisition date.
In many situations, the differential relates to a number of different assets and liabilities. As a means of illustrating the allocation of the differential to various
assets and liabilities, assume that the acquisition-date book values and fair values of Special Foods’ assets and liabilities are as shown in Figure 4–2. The
inventory and land have fair values in excess of their book values, although the buildings and equipment are worth less than their book values.
Bond prices fluctuate as interest rates change. In this example, the value of Special Foods’ bonds payable is higher than the book value. This indicates
that the nominal interest rate on the bonds is higher than the current market interest rate and, therefore, investors are willing to pay a price higher than par for
the bonds. In determining the value of Special Foods, Peerless must recognize that it is assuming a liability that pays an interest rate higher
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than the current market rate. Accordingly, the fair value of Special Foods’ net assets will be less than if the liability had been carried at a lower
interest rate. The resulting consolidated financial statements must recognize the acquisition-date fair values of Special Foods’ liabilities as well as its assets.
F I G U R E 4 –2
Differences between Book and Fair Values of Special Foods’ Identifiable Assets and Liabilities as of January 1, 20X1, the Date of
Combination
Assume that Peerless Products acquires all of Special Foods’ capital stock for $400,000 on January 1, 20X1, by issuing $100,000 of 9 percent bonds,
with a fair value of $100,000, and paying cash of $300,000. The resulting ownership situation can be pictured as follows with a $100,000 differential:
Peerless records the investment on its books with the following entry:
(8)
Investment in Special Foods
400,000
Bonds Payable
100,000
Cash
300,000
Record purchase of Special Foods stock.
The fair value of the consideration that Peerless gave to acquire Special Foods’ stock ($400,000) can be divided between the fair value of Special Foods’
identifiable net assets ($330,000) and goodwill ($70,000), illustrated as follows:
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The total $400,000 consideration exceeds the book value of Special Foods’ net assets of $300,000 (assets of $500,000 less liabilities of $200,000) by
$100,000. Thus, the total differential is $100,000. The total fair value of the net identifiable assets acquired in the combination is $330,000 ($565,000 −
$235,000), based on the data in Figure 4–2. The amount by which the total consideration of $400,000 exceeds the $330,000 fair value of the net identifiable
assets is $70,000, and that amount is assigned to goodwill in the consolidated balance sheet. Assume that Peerless decides to prepare a consolidated balance
sheet as of the date it acquired Special Foods.
The book value portion of the acquisition price is $300,000:
Thus, the basic consolidation entry is as follows:
The reclassification of the differential to the various accounts that are either over- or undervalued on Special Foods’ balance sheet as of the acquisition
date is more complicated than in the previous example. Thus, it is helpful to analyze the differential as follows:
This analysis leads to the following reclassification entry to assign the $100,000 differential to the specific accounts that need to be revalued to reflect
their fair values as of the acquisition date. Moreover, this entry completes the elimination of the investment account from Peerless’s books.
In summary, these two consolidation entries completely eliminate the balance in Peerless’s investment account, and the second entry assigns the
differential to various balance sheet accounts. As in previous examples, it is helpful to visualize how the two consolidation entries “zero out”
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the investment account:
As usual, we eliminate Special Foods’ acquisition date accumulated depreciation against the Buildings and Equipment account balance so that, combined
with the excess value reclassification entry, it will appear as if these fixed assets were recorded at their acquisition costs.
These entries are reflected in the worksheet in Figure 4–3. Although the reclassification entry is somewhat more complex than in the previous example,
the differential allocation is conceptually the same in both cases. In each case, the end result is a consolidated balance sheet with the subsidiary’s assets and
liabilities valued at their fair values at the date of combination.
F I G U R E 4 –3
January 1, 20X1, Worksheet for Consolidated Balance Sheet, Date of Combination; 100 Percent Acquisition at More than Book Value
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100 Percent Ownership Acquired at Less than Fair Value of Net Assets
L O 4 –4
Make calculations and prepare consolidation entries for the consolidation of a wholly owned subsidiary when there is a complex bargain-purchase
differential.
It is not uncommon for companies’ stock to trade at prices that are lower than the fair value of their net assets. These companies are often singled out as
prime acquisition targets. The acquisition price of an acquired company may be less than the fair value of its net assets because some of the acquiree’s assets
or liabilities may have been incorrectly valued or because the transaction reflects a forced sale where the seller was required to sell quickly and was unable to
fully market the sale.
Obviously, if assets or liabilities acquired in a business combination have been incorrectly valued, the errors must be corrected and the assets and liabilities
valued at their fair values. Once this is done, if the fair value of the consideration given is still less than the fair value of the net assets acquired, a gain
attributable to the acquirer is recognized for the difference. In general, as discussed in Chapter 1, a business combination in which (1) the sum of the
acquisition-date fair values of the consideration given, any equity interest already held by the acquirer, and any noncontrolling interest is less than (2) the
amounts at which the identifiable net assets must be valued at the acquisition date (usually fair values) is considered a bargain purchase, and a gain
attributable to the acquirer is recognized for the difference (as specified by ASC 805).
The purpose of the differential is to account for items attributable to the subsidiary company that are not already accounted for by that acquiring entity.
Since the gain on bargain purchase is attributed to the parent, it is recorded directly on the records of the parent, in effect increasing the differential, which is
the difference between the investment account on the parent records and the book value of the subsidiary. The acquirer will record the gain as part of the
acquisition transaction in its individual records.
Illustration of Treatment of Bargain-Purchase
Using the example of Peerless Products and Special Foods, assume that the acquisition-date book values and fair values of Special Foods’ assets and liabilities
are equal except that the fair value of Special Foods’ land is $40,000 more than its book value. On January 1, 20X1, Peerless acquires all of Special Foods’
common stock for $310,000, resulting in a bargain purchase. The resulting ownership situation is as follows:
Peerless records its investment in Special Foods with the following entry on its books:
(9)
Investment in Special Foods
Cash
Gain on Bargain Purchase
340,000
310,000
30,000
Record purchase of Special Foods stock.
In this example, the acquisition-date fair value of Special Foods’ net assets ($340,000) is higher than its book value by $40,000. However, the purchase
price ($310,000) exceeds Special Foods’ book value by only $10,000 and, thus, is less than the fair value of the net identifiable assets acquired. This business
combination, therefore, represents a bargain purchase. All of the acquiree’s assets and liabilities must be valued at fair value, which in this case requires only
Special Foods’ land to be revalued. This revaluation is accomplished in the consolidation worksheet. Assuming Peerless wants to prepare a
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consolidated balance sheet on the acquisition date, the book value portion of the acquisition price is $300,000:
Thus, the basic consolidation entry is the same as in previous examples:
In this example, the total differential relates to the fair value of Special Foods’ land, which is $40,000 more than its book value at acquisition. The
reclassification of this total differential can be summarized as follows:
This analysis leads to the following reclassification entry to assign the $40,000 net differential to the Land.
In summary, these two consolidation entries effectively eliminate the balance in Peerless’s investment account and assign the total differential to the Land
account. As in previous examples, it is helpful to visualize how the two consolidation entries “zero out” the investment account:
When the consolidation worksheet is prepared at the end of the year, the notion of recognizing a gain for the $30,000 excess of the $340,000 fair value of
Special Foods’ net assets over the $310,000 fair value of the consideration given by Peerless in the exchange is correct. However, assuming a consolidation
worksheet is also prepared on the acquisition date (January 1, 20X1), the gain will already be recorded in the parent’s retained earnings account because an
income statement is not prepared on the acquisition date, only a balance sheet (because it is the first day of the year).
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CONSOLIDATED FINANCIAL STATEMENTS—100 PERCENT OWNERSHIP ACQUIRED AT
MORE THAN BOOK VALUE
L O 4 –5
Prepare equity-method journal entries, consolidation entries, and the consolidation worksheet for a wholly owned subsidiary when there is a
complex positive differential.
When an investor company accounts for an investment using the equity method, as illustrated in Chapter 2, it records the amount of differential viewed as
expiring during the period as a reduction of the income recognized from the investee. In consolidation, the differential is assigned to the appropriate asset and
liability balances, and consolidated income is adjusted for the amounts expiring during the period by assigning them to the related expense items (e.g.,
depreciation expense).
Initial Year of Ownership
As an illustration of the acquisition of 100 percent ownership acquired at an amount higher than book value, assume that Peerless Products acquires all of
Special Foods’ common stock on January 1, 20X1, for $387,500, an amount $87,500 in excess of the book value. The acquisition price includes cash of
$300,000 and a 60-day note for $87,500 (paid at maturity during 20X1). At the date of combination, Special Foods holds the assets and liabilities shown in
Figure 4–2. The resulting ownership situation is as follows:
On the acquisition date, all of Special Foods’ assets and liabilities have fair values equal to their book values, except as follows:
Inventory
Land
Buildings & Equipment
Book Value
Fair Value
Fair Value Increment
$ 60,000
$ 65,000
$ 5,000
40,000
50,000
10,000
300,000
360,000
60,000
$400,000
$475,000
$75,000
Of the $87,500 total differential, $75,000 relates to identifiable assets of Special Foods. The remaining $12,500 is attributable to goodwill. The apportionment
of the differential appears as follows. The entire amount of inventory to which the differential relates is sold during 20X1; none is left in ending inventory.
The buildings and equipment have a remaining economic life of 10 years from the date of combination, and Special Foods uses straight-line depreciation. At
the end of 20X1, in evaluating the Investment in Special Foods account for impairment, Peerless’s management determines that the goodwill acquired in the
combination with Special Foods has been impaired. Management determines that a $3,000 goodwill impairment loss should be recognized in the consolidated
income statement.
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For the first year immediately after the date of combination, 20X1, Peerless Products earns income from its own separate operations of $140,000 and
pays dividends of $60,000. Special Foods reports net income of $50,000 and pays dividends of $30,000.
Parent Company Entries
During 20X1, Peerless makes the normal equity-method entries on its books to record its purchase of Special Foods stock and its income and dividends from
Special Foods:
(10)
Investment in Special Foods
387,500
Cash
300,000
Notes Payable
87,500
Record the initial investment in Special Foods.
(11)
Investment in Special Foods
50,000
Income from Special Foods
50,000
Record Peerless’s 100% share of Special Foods’ 20X1 income.
(12)
Cash
30,000
Investment in Special Foods
30,000
Record Peerless’s 100% share of Special Foods’ 20X1 dividend.
In this case, Peerless paid an amount for its investment that was $87,500 in excess of the book value of the shares acquired. As discussed previously,
this difference is a differential that is implicit in the amount recorded in the investment account on Peerless’s books. Because Peerless acquired 100 percent
of Special Foods’ stock, Peerless’s differential included in its investment account is equal to the total differential arising from the business combination.
However, although the differential arising from the business combination must be allocated to specific assets and liabilities in consolidation, the differential on
Peerless’s books does not appear separate from the Investment in Special Foods account. A portion of the differential ($5,000) in the investment account on
Peerless’s books relates to a portion of Special Foods’ inventory that is sold during 20X1. Because Special Foods no longer holds the asset to which that
portion of the differential relates at year-end, that portion of the differential is written off by reducing the investment account and Peerless’s income from
Special Foods. An additional $60,000 of the differential is attributable to the excess of the acquisition-date fair value over book value of Special Foods’
buildings and equipment. As the service potential of the underlying assets expires, Peerless must amortize the additional cost it incurred because of the higher
fair value of those assets. This is accomplished through annual amortization of $6,000 ($60,000 ÷ 10) over the remaining 10-year life beginning in 20X1.
Finally, the goodwill is deemed to be impaired by $3,000 and is also adjusted on Peerless’s books. Thus, the differential must be written off on Peerless’s
books to recognize the cost expiration related to the service expiration of Special Foods’ assets to which it relates. Under the equity method, the differential is
written off periodically from the investment account to Income from Special Foods to reflect these changes in the differential ($5,000 inventory + $6,000
depreciation + $3,000 goodwill impairment = $14,000):
(13)
Income from Special Foods
Investment in Special Foods
14,000
14,000
Record amortization of excess acquisition price.
Consolidation Worksheet—Year of Combination
The following diagrams illustrate the breakdown of the book value and excess value components of the investment account at the beginning and end of the
year.
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Because a year has passed since the acquisition date, the book value of Special Foods’ net assets has changed because it has earned income and declared
dividends. The book value component can be summarized as follows:
This chart leads to the basic consolidation entry. Note that we use a shaded font to distinguish the numbers that appear in the consolidation entry to help the
reader see how it should be constructed.
We then analyze the differential and its changes during the period:
The entire differential amount assigned to the inventory already passed through cost of goods sold during the year. The only other amortization item—the
excess value assigned to the building and equipment—is amortized over a 10-year period ($60,000 ÷ 10 = $6,000 per year). Finally, the goodwill is deemed to
be impaired and worth only $9,500. Because the amortization of the differential has already been written off on Peerless’s books from the investment account
against the Income from Special Foods account, the amortized excess value reclassification entry simply reclassifies these changes in the page 156
differential during the period from the Income from the Special Foods account to the various income statement accounts to which they apply:
Finally, the remaining unamortized differential of $73,500 is reclassified to the correct accounts based on the ending balances (the bottom row) in the excess
value calculations chart:
Recall that Special Foods reports its balance sheet based on the book values of the various accounts. This consolidation entry essentially reclassifies the
differential from the Investment in Special Foods account to the individual accounts that need to be revalued to their amortized fair values as of the balance
sheet date.
In sum, these worksheet entries (1) eliminate the balances in the Investment in Special Foods and Income from Special Foods accounts, (2) reclassify
the amortization of excess value to the proper income statement accounts, and (3) reclassify the remaining differential to the appropriate balance sheet
accounts as of the end of the period.
As usual, we eliminate Special Foods’ acquisition date accumulated depreciation against the Buildings and Equipment account balance.
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The following T-accounts illustrate how the excess value reclassification entry combined with the accumulated depreciation consolidation entry make the
consolidated balances for the Buildings and Equipment and Accumulated Depreciation accounts appear as if these assets had been purchased at the beginning
of the year for their acquisition date fair values ($360,000) and that these “new” assets had then been depreciated $26,000 during the first year of their use
by the newly purchased company.
After the subsidiary income accruals are entered on Peerless’s books, the adjusted trial balance data of the consolidating companies are entered in the
three-part consolidation worksheet as shown in Figure 4–4. We note that because all inventory on hand on the date of combination has been sold during the
year, the $5,000 of differential applicable to inventory is allocated directly to cost of goods sold. The cost of goods sold recorded on Special Foods’ books is
correct for that company’s separate financial statements.
F I G U R E 4 –4
December 31, 20X1, Equity-Method Worksheet for Consolidated Financial Statements, Initial Year of Ownership; 100 Percent
Acquisition at More than Book Value
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However, the cost of the inventory to the consolidated entity is viewed as being $5,000 higher, and this additional cost must be included in consolidated cost
of goods sold. No worksheet entry is needed in future periods with respect to the inventory because it has been expensed and no longer is on the subsidiary’s
books. The portion of the differential related to the inventory no longer exists on Peerless’s books after 20X1 because the second consolidation entry
removed it from the investment account.
The differential assigned to depreciable assets must be charged to depreciation expense over the remaining lives of those assets. From a consolidated
viewpoint, the acquisition-date fair value increment associated with the depreciable assets acquired becomes part of the assets’ depreciation base.
Depreciation already is recorded on the subsidiary’s books based on the original cost of the assets to the subsidiary, and these amounts are carried to the
consolidation worksheet as depreciation expense.
The difference between the $387,500 fair value of the consideration exchanged and the $375,000 fair value of Special Foods’ net identifiable assets is
assumed to be related to the excess earning power of Special Foods. This difference is entered in the worksheet in Figure 4–4. A distinction must be made
between journal entries recorded on the parent’s books under equity-method reporting and the consolidation entries needed in the worksheet to prepare the
consolidated financial statements. Again, we distinguish between actual equity-method journal entries on the parent’s books (not shaded) and worksheet
consolidation entries (shaded).
Consolidated Net Income and Retained Earnings
As can be seen from the worksheet in Figure 4–4, consolidated net income for 20X1 is $176,000 and consolidated retained earnings on December 31, 20X1,
is $416,000. These amounts can be computed as shown in Figure 4–5.
Second Year of Ownership
The consolidation procedures employed at the end of the second year, and in periods thereafter, are basically the same as those used at the end of the first
year. Consolidation two years after acquisition is illustrated by continuing the example used for 20X1. During 20X2, Peerless Products earns income of
$160,000 from its own separate operations and pays dividends of $60,000; Special Foods reports net income of $75,000 and pays dividends of $40,000. No
further impairment of the goodwill from the business combination occurs during 20X2.
FYI
The examples presented in this chapter use January 1 as the acquisition date. Examples are presented in
Chapter 10 where a subsidiary is acquired at a date during the year rather than at the beginning or end of
the year.
FIGURE 4–5
Consolidated Net Income and Retained Earnings, 20X1; 100 Percent Acquisition at
More than Book Value
Consolidated net income, 20X1:
Peerless’s separate operating income
$140,000
Special Foods’ net income
50,000
Write-off of differential related to inventory sold during 20X1
(5,000)
Amortization of differential related to buildings & equipment in 20X1
(6,000)
Goodwill impairment loss
(3,000)
Consolidated net income, 20X1
$176,000
Consolidated retained earnings, December 31, 20X1:
Peerless’s retained earnings on date of combination, January 1, 20X1
Peerless’s separate operating income, 20X1
$300,000
140,000
Special Foods’ 20X1 net income
50,000
Write-off of differential related to inventory sold during 20X1
(5,000)
Amortization of differential related to buildings & equipment in 20X1
(6,000)
Goodwill impairment loss
(3,000)
Dividends declared by Peerless, 20X1
Consolidated retained earnings, December 31, 20X1
(60,000)
$416,000
page 159
Parent Company Entries
Peerless Products records the following entries on its separate books during 20X2:
(14)
Investment in Special Foods
75,000
Income from Special Foods
75,000
Record Peerless’s 100% share of Special Foods’ 20X2 income.
(15)
Cash
40,000
Investment in Special Foods
40,000
Record Peerless’s 100% share of Special Foods’ 20X2 dividend.
(16)
Income from Special Foods
Investment in Special Foods
Record amortization of excess acquisition price.
6,000
6,000
The book value component can be summarized as follows:
The numbers in this chart in the shaded font determine the basic consolidation entry:
The entire differential amount assigned to the inventory already passed through cost of goods sold during the prior year period. The only other amortization
item is the excess value assigned to the buildings and equipment, which continues to be written off over a 10-year period ($60,000 ÷ 10 = $6,000) as
illustrated in the following chart. Again, the goodwill is deemed not to be further impaired this year.
page 160
Because the amortization of the differential was already written off from the investment account against the Income from Special Foods account, the
change to the differential (i.e., the middle row of the chart) is simply reclassified from the Income from Special Foods account to the income statement
account to which it applies during the consolidation process. Then, the remaining amount of the differential at year end (i.e., the bottom row of the chart) is
reclassified to the various balance sheet accounts to which they apply:
These consolidation entries (1) eliminate the balances in the Investment in Special Foods and Income from Special Foods accounts, (2) reclassify the
amortization of excess value to the proper income statement accounts, and (3) reclassify the remaining differential to the appropriate balance sheet accounts
as of the end of the accounting period. The following T-accounts illustrate how the three consolidation entries zero out the equity-method investment and
income accounts:
Again, we repeat the same accumulated depreciation consolidation entry this year (and every year as long as Special Foods owns the assets) that we used
in the initial year.
page 161
Consolidation Worksheet—Second Year Following Combination
The worksheet for the second year, 20X2, completes the two-year cycle as illustrated in Figure 4–6. Moreover, as can be seen from the worksheet,
consolidated net income for 20X2 is $229,000 and consolidated retained earnings on December 31, 20X2, is $585,000, as illustrated in Figure 4–7.
F I G U R E 4 –6
December 31, 20X2, Equity-Method Worksheet for Consolidated Financial Statements, Second Year of Ownership; 100 Percent Acquisition
at More than Book Value
FIGURE 4–7
Consolidated Net Income and Retained Earnings, 20X2; 100 Percent Acquisition at
More than Book Value
Consolidated net income, 20X2:
Peerless’s separate operating income
Special Foods’ net income
Amortization of differential related to buildings & equipment in 20X2
Consolidated net income, 20X2
$160,000
75,000
(6,000)
$229,000
Consolidated retained earnings, December 31, 20X2:
Consolidated retained earnings, December 31, 20X1
Peerless’s separate operating income, 20X2
Special Foods’ 20X2 net income
Amortization of differential related to buildings & equipment in 20X2
Dividends declared by Peerless, 20X2
Consolidated retained earnings, December 31, 20X2
$416,000
160,000
75,000
(6,000)
(60,000)
$585,000
page 162
INTERCOMPANY RECEIVABLES AND PAYABLES
L O 4 –6
Understand and explain the elimination of basic intercompany transactions.
All forms of intercompany receivables and payables need to be eliminated when consolidated financial statements are prepared. From a single-company
viewpoint, a company cannot owe itself money. If a company owes an affiliate $1,000 on account, one company carries a $1,000 receivable on its separate
books and the other has a payable for the same amount. When consolidated financial statements are prepared, the following consolidation entry is needed in
the consolidation worksheet:
Accounts Payable
1,000
Accounts Receivable
1,000
Eliminate intercompany receivable/payable.
If no consolidation entry is made, both the consolidated assets and liabilities are overstated by an equal amount.
If the intercompany receivable/payable bears interest, all accounts related to the intercompany claim must be eliminated in the preparation of consolidated
statements, including the receivable/payable, interest income, interest expense, and any accrued interest on the intercompany claim. Other forms of
intercorporate claims, such as bonds, are discussed in subsequent chapters. In all cases, failure to eliminate these claims can distort consolidated balances.
As a result, the magnitude of debt of the combined entity may appear to be greater than it is, working capital ratios may be incorrect, and other types of
comparisons may be distorted.
PUSH-DOWN ACCOUNTING
L O 4 –7
Understand and explain the basics of push-down accounting.
The term push-down accounting refers to the practice of revaluing an acquired subsidiary’s assets and liabilities to their fair values directly on that
subsidiary’s books at the date of acquisition. If this practice is followed, the revaluations are recorded once on the subsidiary’s books at the date of
acquisition and, therefore, are not made in the consolidation worksheets each time consolidated statements are prepared.
On November 18, 2014, the FASB issued a new standard that gives all companies the option to apply push-down accounting when they are acquired by
another party (a change-in-control event). Concurrently, the SEC staff eliminated its guidance which had previously required or precluded push-down
accounting for registrants generally based on the percentage of ownership. These developments make push-down accounting optional (but not required) for
all subsidiaries that file financial reports with the SEC separate from their parent company’s consolidated financial statements. This separate reporting by a
subsidiary is only required in a few cases, usually because the subsidiary has issued public debt.
Those who favor push-down accounting argue that the change in the subsidiary’s ownership in an acquisition is reason for adopting a new basis of
accounting for the subsidiary’s assets and liabilities, and that this new basis of accounting should be reflected directly in the subsidiary’s records. This
argument is most persuasive when the subsidiary is wholly owned, is consolidated, or has its separate financial statements included with the parent’s
statements immediately following the acquisition.
Other users may prefer not to use push-down accounting, instead preferring the historical basis to avoid distorting income statement trends as a result of
increased amortization and depreciation expense. From their viewpoint, push-down accounting results in the revaluation of the assets and liabilities of a
continuing enterprise, a practice that normally is not acceptable. Users that are focused on cash flow and EBITDA measures may be indifferent as to using
push-down accounting because these measures are often not significantly affected by the application of push-down accounting.
When push-down accounting is used, the revaluation of assets and liabilities on a subsidiary’s books involves making an entry to debit or credit each asset
and liability account to be revalued, with the balancing entry to a revaluation capital account (this amount is usually a credit). The revaluation capital account
is part of the subsidiary’s stockholders’ equity. Once the revaluations are made on the books of the subsidiary, the new book values of the subsidiary’s
assets, including goodwill, are equal to the acquisition cost of the subsidiary. Thus, no differential arises in the consolidation process. The
page 163
investment consolidation entry in a consolidation worksheet prepared immediately after acquisition of a subsidiary and revaluation of its assets
on its books might appear as follows:
Capital Stock—Subsidiary
XXX
Retained Earnings
XXX
Revaluation Capital
XXX
Investment in Subsidiary Stock
XXX
Eliminate investment balance.
Note that the Revaluation Capital account, as part of the subsidiary’s stockholders’ equity, is eliminated in preparing consolidated statements. We provide a
more detailed example of push-down accounting in Appendix 4A.
SUMMARY OF KEY CONCEPTS
Worksheet consolidation entries are needed to remove the effects of intercompany ownership and intercompany transactions so the consolidated financial
statements appear as if the separate companies are actually one. These worksheet entries are needed to (1) eliminate the book value portion of the parent’s
subsidiary investment and the subsidiary’s stockholders’ equity accounts, (2) reclassify the amortization of excess value from the parent’s income from subsidiary
account to the correct income statement line items, (3) assign any remaining differential to specific assets and liabilities, and (4) net the subsidiary’s accumulated
depreciation as of the acquisition date against the historical cost of property, plant, and equipment.
Consolidated net income is computed in simple cases for a parent and a wholly owned subsidiary as the total of the parent’s income from its own operations and
the subsidiary’s net income, adjusted for the write-off of differential, if appropriate. In this situation, consolidated retained earnings is computed as the total of the
parent’s retained earnings, excluding any income from the subsidiary, plus the subsidiary’s cumulative net income since acquisition adjusted for the differential
amount.
When a subsidiary is acquired for an amount higher than its book value, some parent companies may prefer to assign the differential to individual assets and
liabilities directly on the subsidiary’s books at the time of acquisition, thereby eliminating the need for revaluation entries in the consolidation worksheet each
period. This procedure is called push-down accounting.
KEY TERMS
bargain purchase, 151
differential, 138
goodwill, 147
push-down accounting, 147
Appendix 4A
Push-Down Accounting Illustrated
When a subsidiary is acquired in a business combination, its assets and liabilities must be revalued to their fair values as of the date of combination for
consolidated reporting. If push-down accounting is employed, the revaluations are made as of the date of combination directly on the books of the subsidiary, and
no consolidation entries related to the differential are needed in the consolidation worksheets.
The following example illustrates the consolidation process when assets and liabilities are revalued directly on a subsidiary’s books rather than through
revaluation entries on a consolidation worksheet. Assume that Peerless Products purchases all of Special Foods’ common stock on January 1, 20X1, for $370,000
cash. The purchase price is $70,000 in excess of Special Foods’ book value. Of the $70,000 total differential, $10,000 is related to land held by Special Foods and
$60,000 is related to buildings and equipment having a 10-year remaining life. Accumulated depreciation on Special Foods’ books at the acquisition date is $300,000.
Peerless accounts for its investment in Special Foods stock using the equity method.
Peerless records the acquisition of stock on its books with the following entry:
(17)
Investment in Special Foods
370,000
Cash
370,000
Record the initial investment in Special Foods.
page 164
In contrast to a worksheet revaluation, the use of push-down accounting involves the revaluation of the assets on the separate books of Special Foods and
alleviates the need for revaluation entries in the consolidation worksheet each period. If push-down accounting is used to revalue Special Foods’ assets, the
following entry is made directly on its books:
(18)
Land
10,000
Buildings & Equipment
60,000
Revaluation Capital
Record the increase in fair value of land and buildings.
70,000
This entry increases the amount at which the land and the buildings and equipment are shown in Special Foods’ separate financial statements and gives rise to a
revaluation capital account that is shown in the stockholders’ equity section of Special Foods’ balance sheet. Special Foods records $6,000 additional depreciation
on its books to reflect the amortization over 10 years of the $60,000 write-up of buildings and equipment.
Entry (19) removes the accumulated depreciation on the acquisition date so that the buildings and equipment appear at their acquisition date fair value with zero
accumulated depreciation.
(19)
Accumulated Depreciation
300,000
Buildings & Equipment
300,000
Assuming Special Foods recorded net income of $44,000 and paid dividends of $30,000 during 20X1, Peerless records the following entries on its parentcompany books:
(20)
Investment in Special Foods
44,000
Income from Special Foods
44,000
Record Peerless’s 100% share of Special Foods’ 20X1 income.
(21)
Cash
30,000
Investment in Special Foods
30,000
Record Peerless’s 100% share of Special Foods’ 20X1 dividend.
Because the revaluation is recorded on the subsidiary’s books, Special Foods’ book value is then equal to the fair value of the consideration given in the
combination. Therefore, no differential exists, and Peerless need not record any amortization associated with the investment. The net amount of income from Special
Foods recorded by Peerless is the same regardless of whether or not push-down accounting is employed. The book value portion of the investment account can be
summarized as follows:
The basic consolidation entry is very similar to the original example presented previously except that now (1) it must also eliminate Special Foods’ revaluation
capital account and (2) the amount of the Investment in Special Foods included in the basic entry comprises both the original book value before push-down
accounting was applied as well as the increased value of the assets purchased:
Basic Consolidation Entry:
Common Stock
200,000
Retained Earnings
Revaluation Capital
Income from Special Foods
100,000
70,000
44,000
Dividends Declared
Investment in Special Foods
30,000
384,000
Again, because there is no differential after push-down accounting is applied, the basic consolidation entry completely eliminates the balance in
Peerless’s investment account on the balance sheet as well as the Income from Special Foods account on the income statement.
page 165
Figure 4–8 shows the consolidation worksheet prepared at the end of 20X1 and includes the effects of revaluing Special Foods’ assets. Note that Special Foods’
Land and Buildings and Equipment have been increased by $10,000 and $60,000, respectively. Also note the Revaluation Capital account in Special Foods’
stockholders’ equity. Because the revaluation was accomplished directly on the books of Special Foods, only the basic consolidation entry is needed in the
worksheet illustrated in Figure 4–8.
F I G U R E 4 –8
December 31, 20X1, Equity-Method Worksheet for Consolidated Financial Statements, Initial Year of Ownership; 100 Percent
Acquisition at More than Book Value; Push-Down Accounting
page 166
QUESTIONS
Q4–1
When is the carrying value of the investment account reduced under equity-method reporting?
LO 4–1
Q4–2
What is a differential? How is a differential treated by an investor in computing income from an
investee under (a) cost-method and (b) equity-method reporting?
LO 4–1
Q4–3
Turner Manufacturing Corporation owns 100 percent of the common shares of Straight Lace
Company. If Straight Lace reports net income of $100,000 for 20X5, what factors may cause
Turner to report less than $100,000 of income from the investee?
LO 4–1
Q4–4
What is the term differential used to indicate?
LO 4–1
Q4–5
What conditions must exist for a negative differential to occur?
LO 4–1
Q4–6
What portion of the book value of the net assets held by a subsidiary at acquisition is included in
the consolidated balance sheet?
LO 4–2
Q4–7
What portion of the fair value of a subsidiary’s net assets normally is included in the
consolidated balance sheet following a business combination?
LO 4–2
Q4–8
What happens to the differential in the consolidation worksheet prepared as of the date of
combination? How is it reestablished so that the proper balances can be reported the following
year?
LO 4–3
Q4–9
Explain why consolidated financial statements become increasingly important when the
differential is very large.
LO 4–2
Q4–10
Give a definition of consolidated net income.
LO 4–3
Q4–11
When Ajax was preparing its consolidation worksheet, the differential was properly assigned to
buildings and equipment. What additional entry generally must be made in the worksheet?
LO 4–5
Q4–12
What determines whether the balance assigned to the differential remains constant or decreases
each period?
LO 4–3, 4–4
Q4–13
What does the term push-down accounting mean?
LO 4–7
Q4–14
Under what conditions is push-down accounting considered appropriate?
LO 4–7
Q4–15
What happens to the differential when push-down accounting is used following a business
combination?
LO 4–7
CASES
C4–1
Reporting Significant Investments in Common Stock
LO 4–1
Analysis
The reporting treatment for investments in common stock depends on the level of ownership and the ability to influence the investee’s policies. The reporting
treatment may even change over time as ownership levels or other factors change. When investees are not consolidated, the investments typically are reported in
the Investments section of the investor’s balance sheet. However, the investor’s income from those investments is not always easy to find in the investor’s income
statement.
Required
a.
On August 4, 2015, Harley-Davidson Inc. completed its purchase of certain assets and liabilities from Fred Deeley Imports, Ltd. (Deeley Imports) including, among
other things, the acquisition of the exclusive right to distribute the Company’s motorcycles and other products in Canada for total consideration of $59.9 million.
How much of this price was attributed to intangible assets? How much was attributed to goodwill?
b.
How does Chevron Corporation account for its investments in affiliated companies? How does the company account for issuances of additional stock by affiliates
that change the company’s proportionate dollar share of the affiliates’ equity? How does Chevron treat a differential associated with an equity-method
investment? How does Chevron account for the impairment of an equity investment?
c.
Does Sears have any investments in companies that it accounts for using the equity method? Where are these investments reported in the balance sheet, and
where is the income from these investments reported in the income statement?
page 167
C4–2
Assigning an Acquisition Differential
LO 4–2
Analysis
Ball Corporation’s owners recently offered to sell 100 percent of their ownership to Timber Corporation for$450,000. Timber’s business manager was told that Ball’s
book value was $300,000, and she estimates the fair value of its net assets at approximately $600,000. Ball has relatively old equipment and manufacturing facilities
and uses a LIFO basis for inventory valuation of some items and a FIFO basis for others.
Required
If Timber accepts the offer and acquires a controlling interest in Ball, what difficulties are likely to be encountered in assigning the differential?
C4–3
Negative Retained Earnings
LO 4–2, 4–3
Understanding
Although Sloan Company had good earnings reports in 20X5 and 20X6, it had a negative retained earnings balance on December 31, 20X6. Jacobs Corporation
purchased 100 percent of Sloan’s common stock on January 1, 20X7.
Required
a.
Explain how Sloan’s negative retained earnings balance is reflected in the consolidated balance sheet immediately following the acquisition.
b.
Explain how the existence of negative retained earnings changes the consolidation worksheet entries.
c.
Can goodwill be recorded if Jacobs pays more than book value for Sloan’s shares? Explain.
C4–4
Balance Sheet Reporting Issues
LO 4–1, 4–3
Judgment
Crumple Car Rentals is planning to expand into the western part of the United States and needs to acquire approximately 400 additional automobiles for rental
purposes. Because Crumple’s cash reserves were substantially depleted in replacing the bumpers on existing automobiles with new “fashion plate” bumpers, the
expansion funds must be acquired through other means. Crumple’s management has identified two options:
1. Issue additional debt.
2. Create a wholly owned leasing subsidiary that would borrow the money with a guarantee for payment from Crumple. The subsidiary would then lease the cars
to the parent.
The acquisition price of the cars is approximately the same under both alternatives.
Required
a.
You have been asked to compare and contrast the two alternatives from the perspective of
(1) The impact on Crumple’s consolidated balance sheet.
(2) Their legal ramifications.
(3) The ability to control the maintenance, repair, and replacement of automobiles.
b.
What other alternatives might be used in acquiring the required automobiles?
c.
Select your preferred alternative and show why it is the better choice.
C4–5
Subsidiary Ownership: International Lease Finance Corporation
LO 4–1, 4–2
Research
Most subsidiaries are wholly owned, although only majority ownership is usually all that is required for consolidation. The parent’s ownership may be direct or
indirect. Frequently, a parent’s direct subsidiaries have subsidiaries of their own, thus providing the parent with indirect ownership of the subsidiary’s subsidiaries.
Required
International Lease Finance Corporation is a very large leasing company. It leases equipment that everyone is familiar with and many have used.
(1) Specifically, what is the principal business of International Lease Finance Corporation?
(2) In what city is International Lease headquartered?
(3) In what state is International Lease incorporated?
(4) Where is International Lease’s common stock traded?
(5) Who are the direct owners of International Lease?
page 168
EXERCISES
E4–1
Equity Method Reporting with a Differential
LO 4–1
Pirate Corporation purchased 100 percent ownership of Ship Company on January 1, 20X5, for $270,000. On that date, the book value of Ship’s reported net assets
was $200,000. The excess over book value paid is attributable to depreciable assets with a remaining useful life of 10 years. Net income and dividend payments of
Ship in the following periods were as shown below:
Year
Net Income
Dividends
20X5
$20,000
$ 5,000
20X6
40,000
15,000
20X7
20,000
35,000
Required
Prepare journal entries on Pirate Corporation’s books relating to its investment in Ship Company for each of the three years, assuming it accounts for the investment
using the equity method.
E4–2
Differential Assigned to Patents
LO 4–1
Pizza Corporation purchased 100 percent of the common stock of Slice Corporation on January 1, 20X2, by issuing 45,000 shares of its $6 par value common stock.
The market price of Pizza’s shares at the date of issue was $24. Slice reported net assets with a book value of $980,000 on that date. The amount paid in excess of the
book value of Slice’s net assets was attributed to the increased value of patents held by Slice with a remaining useful life of eight years. Slice reported net income of
$56,000, paid dividends of $20,000 in 20X2, reported a net loss of $44,000, and paid dividends of $10,000 in 20X3.
Required
Assuming that Pizza Corporation uses the equity method in accounting for its investment in Slice Corporation, prepare all journal entries for Pizza for 20X2 and
20X3.
E4–3
Differential Assigned to Copyrights
LO 4–1
Planet Corporation acquired 100 percent of the voting common stock of Saturn Company on January 1, 20X7, by issuing bonds with a par value and fair value of
$670,000 and making a cash payment of $24,000. At the date of acquisition, Saturn reported assets of $740,000 and liabilities of $140,000. The book values and fair
values of Saturn’s net assets were equal except for land and copyrights. Saturn’s land had a fair value $16,000 higher than its book value. All of the remaining
purchase price was attributable to the increased value of Saturn’s copyrights with a remaining useful life of eight years. Saturn Company reported a loss of $88,000
in 20X7 and net income of $120,000 in 20X8. Saturn paid dividends of $24,000 each year.
Required
Assuming that Planet Corporation uses the equity method in accounting for its investment in Saturn Company, prepare all journal entries for Planet for 20X7 and
20X8.
E4–4
Differential Attributable to Depreciable Assets
LO 4–1
Planner Corporation purchased 100 percent of Schedule Company’s stock on January 1, 20X4, for $340,000. On that date, Schedule reported net assets with a
historical cost of $300,000 and a fair value of $340,000. The difference was due to the increased value of buildings with a remaining life of 10 years. During 20X4 and
20X5, Schedule reported net income of $10,000 and $20,000 and paid dividends of $6,000 and $9,000, respectively.
Required
Assuming that Planner Corporation uses (a) the equity method and (b) the cost method in accounting for its ownership of Schedule Company, give the journal
entries that Planner recorded in 20X4 and 20X5.
page 169
E4–5
Investment Income
LO 4–1
Plastic Company purchased 100 percent of Spoon Company’s voting common stock for $648,000 on January 1, 20X4. At that date, Spoon reported assets of
$690,000 and liabilities of $230,000. The book values and fair values of Spoon’s assets were equal except for land, which had a fair value $108,000 more than book
value, and equipment, which had a fair value $80,000 more than book value. The remaining economic life of all depreciable assets at January 1, 20X4, was five years.
Spoon reported net income of $68,000 and paid dividends of $34,000 in 20X4.
Required
Compute the amount of investment income to be reported by Plastic for 20X4.
E4–6
Determination of Purchase Price
LO 4–1
Player Corporation purchased 100 percent of Scout Company’s common stock on January 1, 20X5, and paid $28,000 above book value. The full amount of the
additional payment was attributed to amortizable assets with a life of eight years remaining at January 1, 20X5. During 20X5 and 20X6, Scout reported net income of
$33,000 and $6,000 and paid dividends of $15,000 and $12,000, respectively. Player uses the equity method in accounting for its investment in Scout and reported a
balance in its investment account of $161,000 on December 31, 20X6.
Required
Compute the amount paid by Player to purchase Scout shares.
E4–7
Equity Entries With a Differential
LO 4–1, 4–2
Pistol Corporation purchased 100 percent ownership of Scope Products on January 1, 20X6, for $56,000, at which time Scope Products reported retained earnings of
$10,000 and capital stock outstanding of $30,000. The differential was attributable to patents with a life of eight years. Income and dividends of Scope Products were
Year
Net Income
Dividends
20X6
$16,000
$6,000
20X7
24,000
8,000
20X8
32,000
8,000
Required
1. Give the equity method entries that Pistol should record to account for this investment in 20X6, 20X7, and 20X8.
2. What is the balance of the Investment in Scope account on Pistol’s balance sheet at December 31, 20X8, after all required equity method entries have been
recorded?
E4–8
Differential Assigned to Land and Equipment
LO 4–1
Pitch Corporation purchased 100 percent ownership of Southpaw Corporation on January 1, 20X4, for $65,000, which was $10,000 above the underlying book value.
Half the additional amount was attributable to an increase in the value of land held by Southpaw, and half was due to an increase in the value of equipment. The
equipment had a remaining economic life of five years on January 1, 20X4. During 20X4, Southpaw reported net income of $12,000 and paid dividends of $4,500.
Required
Give the journal entries that Pitch Corporation recorded during 20X4 related to its investment in Southpaw Corporation, assuming Pitch uses the equity method in
accounting for its investment.
page 170
E4–9
Equity Entries with Goodwill
LO 4–1, 4–2
Softball Corporation reported the following balances at January 1, 20X9:
Item
Book Value
Cash
Fair Value
$ 45,000
$ 45,000
60,000
60,000
Inventory
120,000
130,000
Buildings & Equipment
300,000
240,000
Accounts Receivable
Less: Accumulated Depreciation
(150,000)
Total Assets
$375,000
$475,000
Accounts Payable
$ 75,000
$ 75,000
Common Stock ($10 par value)
100,000
Additional Paid-In Capital
30,000
Retained Earnings
Total Liabilities & Equities
170,000
$375,000
On January 1, 20X9, Pitcher Corporation purchased 100 percent of Softball’s stock. All tangible assets had a remaining economic life of 10 years at January 1, 20X9.
Both companies use the FIFO inventory method. Softball reported net income of $16,000 in 20X9 and paid dividends of $3,200. Pitcher uses the equity method in
accounting for its investment in Softball.
Required
Give all journal entries that Pitcher recorded during 20X9 with respect to its investment assuming Pitcher paid $437,500 for the ownership of Softball on January 1,
20X9. The amount of the differential assigned to goodwill is not impaired.
E4–10
Multiple-Choice Questions on Consolidation Process
LO 4–1, 4–2, 4–6
Select the most appropriate answer for each of the following questions:
1. Goodwill is
a. Seldom reported because it is too difficult to measure.
b. Reported when more than book value is paid in purchasing another company.
c. Reported when the fair value of the acquiree is higher than the fair value of the net identifiable assets acquired.
d. Generally smaller for small companies and increases in amount as the companies acquired increase in size.
2. [AICPA Adapted] Wright Corporation includes several subsidiaries in its consolidated financial statements. In its December 31, 20X2, trial balance, Wright had
the following intercompany balances before consolidation entries:
Debit
Current receivable due from Main Company
$ 32,000
Noncurrent receivable from Main Company
114,000
Cash advance to Corn Corporation
Credit
6,000
Cash advance from King Company
$ 15,000
Intercompany payable to King Company
101,000
In its December 31, 20X2, consolidated balance sheet, what amount should Wright report as intercompany receivables?
a.
$152,000
b.
$146,000
c.
$36,000
d.
$0
3. Beni Corporation acquired 100 percent of Carr Corporation’s outstanding capital stock for $430,000 cash. Immediately before the purchase, the
balance sheets of both corporations reported the following:
Beni
Carr
Assets
$2,000,000
$750,000
Liabilities
$
750,000
$400,000
1,000,000
310,000
Common Stock
Retained Earnings
Liabilities & Stockholders’ Equity
250,000
$2,000,000
page 171
40,000
$750,000
At the date of purchase, the fair value of Carr’s assets was $50,000 more than the aggregate carrying amounts. In the consolidated balance sheet prepared
immediately after the purchase, the consolidated stockholders’ equity should amount to
a. $1,680,000.
b. $1,650,000.
c. $1,600,000.
d. $1,250,000.
Note: Questions 4 and 5 are based on the following information:
Nugget Company’s balance sheet on December 31, 20X6, was as follows:
Liabilities & Stockholders’
Equity
Assets
Cash
100,000
Current Liabilities
Accounts Receivable
200,000
Long-Term Debt
500,000
Inventories
500,000
Common Stock (par $1 per share)
100,000
Property, Plant & Equipment
(net)
900,000
Additional Paid-In Capital
200,000
Retained Earnings
600,000
Total Assets
$
$1,700,000
Total Liabilities & Stockholders’
Equity
$
300,000
$1,700,000
On December 31, 20X6, Gold Company acquired all of Nugget’s outstanding common stock for $1,500,000 cash. On that date, the fair (market) value of Nugget’s
inventories was $450,000, and the fair value of Nugget’s property, plant, and equipment was $1,000,000. The fair values of all other assets and liabilities of Nugget
were equal to their book values.
4. As a result of Gold’s acquisition of Nugget, the consolidated balance sheet of Gold and Nugget should reflect goodwill in the amount of
a. $500,000.
b. $550,000.
c. $600,000.
d. $650,000.
5. Assuming Gold uses the equity method to account for investments and that Gold’s (unconsolidated) balance sheet on December 31, 20X6, reflected retained
earnings of $2,000,000, what amount of retained earnings should be shown in the December 31, 20X6, consolidated balance sheet of Gold and its new
subsidiary, Nugget?
a. $2,000,000
b. $2,600,000
c. $2,800,000
d. $3,150,000
page 172
E4–11
Multiple-Choice Questions on Consolidation [AICPA Adapted]
LO 4–3, 4–6
Select the correct answer for each of the following questions.
1. On January 1, 20X1, Prim Inc. acquired all of Scrap Inc.’s outstanding common shares for cash equal to the stock’s book value. The carrying amounts of Scrap’s
assets and liabilities approximated their fair values, except that the carrying amount of its building was more than fair value. In preparing Prim’s 20X1
consolidated income statement, which of the following adjustments would be made?
a. Decrease depreciation expense and recognize goodwill amortization.
b. Increase depreciation expense and recognize goodwill amortization.
c. Decrease depreciation expense and recognize no goodwill amortization.
d. Increase depreciation expense and recognize no goodwill amortization.
2. The first examination of Rudd Corporation’s financial statements was made for the year ended December 31, 20X8. The auditor found that Rudd had acquired
another company on January 1, 20X8, and had recorded goodwill of $100,000 in connection with this acquisition. Although a friend of the auditor believes the
goodwill will last no more than five years, Rudd’s management has found no impairment of goodwill during 20X8. In its 20X8 financial statements, Rudd should
report
Amortization Expense
0
Goodwill
a.
$
b.
$100,000
$100,000
$
c.
$ 20,000
$ 80,000
d.
$
$
0
0
0
3. Consolidated financial statements are being prepared for a parent and its four wholly owned subsidiaries that have intercompany loans of $100,000 and
intercompany profits of $300,000. How much of these intercompany loans and profits should be eliminated?
Intercompany
Loans
Profits
a.
$
0
$
b.
$
0
$300,000
0
c.
$100,000
$
d.
$100,000
$300,000
0
4. On April 1, 20X8, Plum Inc. paid $1,700,000 for all of Long Corp.’s issued and outstanding common stock. On that date, the costs and fair values of Long’s
recorded assets and liabilities were as follows:
Cost
Cash
$
160,000
Fair Value
$
160,000
Inventory
480,000
460,000
Property, plant & equipment (net)
980,000
1,040,000
Liabilities
(360,000)
Net assets
$1,260,000
(360,000)
$1,300,000
In Plum’s March 31, 20X9, consolidated balance sheet, what amount of goodwill should be reported as a result of this business combination?
a. $360,000.
b. $396,000.
c. $400,000.
d. $440,000.
page 173
E4–12
Consolidation Entries with Differential
LO 4–3
On June 10, 20X8, Playoff Corporation acquired 100 percent of Series Company’s common stock. Summarized balance sheet data for the two companies immediately
after the stock acquisition are as follows:
Playoff Corp.
Item
Series Company
Book Value
Cash
Fair Value
$ 15,000
$ 5,000
$
5,000
Accounts Receivable
30,000
10,000
10,000
Inventory
80,000
20,000
25,000
Buildings & Equipment (net)
120,000
50,000
70,000
Investment in Series Stock
100,000
Total
$345,000
$85,000
$110,000
Accounts Payable
$ 25,000
$ 3,000
$
Bonds Payable
150,000
25,000
Common Stock
55,000
20,000
Retained Earnings
115,000
37,000
$345,000
$85,000
Total
3,000
25,000
$ 28,000
Required
a.
Give the consolidation entries required to prepare a consolidated balance sheet immediately after the acquisition of Series Company shares.
b.
Explain how consolidation entries differ from other types of journal entries recorded in the normal course of business.
E4–13
Balance Sheet Consolidation
LO 4–5
Plaza Corporation acquired 100 percent of Square Corporation’s voting common stock on December 31, 20X4, for $395,000. At the date of combination, Square
reported the following:
Cash
$120,000
Current Liabilities
$ 80,000
Inventory
100,000
Long-Term Liabilities
200,000
Buildings (net)
420,000
Common Stock
120,000
Retained Earnings
240,000
Total
$640,000
Total
$640,000
At December 31, 20X4, the book values of Square’s net assets and liabilities approximated their fair values, except for buildings, which had a fair value of $20,000
less than book value, and inventories, which had a fair value $36,000 more than book value.
Required
Plaza Corporation wishes to prepare a consolidated balance sheet immediately following the business combination. Give the consolidation entry or entries needed
to prepare a consolidated balance sheet at December 31, 20X4.
E4–14
Acquisition with Differential
LO 4–2, 4–3
Plumber Corporation acquired all of Socket Corporation’s voting shares on January 1, 20X2, for $470,000. At that time, Socket reported common stock outstanding
of $80,000 and retained earnings of $130,000. The book values of Socket’s assets and liabilities approximated fair values, except for land, which had a book value of
$80,000 and a fair value of $100,000, and buildings, which had a book value of $220,000 and a fair value of $400,000. Land and buildings are the only noncurrent
assets that Socket holds.
Required
a.
Compute the amount of goodwill at the date of acquisition.
b.
Give the consolidation entry or entries required immediately following the acquisition to prepare a consolidated balance sheet.
page 174
E4–15
Balance Sheet Worksheet with Differential
LO 4–5
Plump Corporation acquired 100 percent of Slim Corporation’s common stock on December 31, 20X2, for $189,000. Data from the balance sheets of the two
companies included the following amounts as of the date of acquisition:
Item
Plump
Corporation
Cash
$ 26,000
$ 18,000
87,000
37,000
Inventory
110,000
60,000
Buildings & Equipment (net)
220,000
150,000
Investment in Slim Corporation Stock
189,000
Accounts Receivable
Slim
Corporation
Total Assets
$632,000
$265,000
Accounts Payable
$ 92,000
$ 35,000
Notes Payable
150,000
80,000
Common Stock
100,000
60,000
Retained Earnings
290,000
90,000
$632,000
$265,000
Total Liabilities & Stockholders’ Equity
At the date of the business combination, Slim’s net assets and liabilities approximated fair value except for inventory, which had a fair value of $84,000, and
buildings and equipment (net), which had a fair value of $165,000.
Required
a.
Give the consolidation entry or entries needed to prepare a consolidated balance sheet immediately following the business combination.
b.
Prepare a consolidation balance sheet worksheet.
E4–16
Worksheet for Wholly Owned Subsidiary
LO 4–5
Pint Enterprises acquired 100 percent of Saloon Builders’ stock on December 31, 20X4. Balance sheet data for Pint and Saloon on January 1, 20X5, are as follows:
Pint
Enterprises
Saloon
Builders
$ 80,000
$ 30,000
Inventory
150,000
350,000
Buildings & Equipment (net)
430,000
80,000
Investment in Saloon Builders
167,000
Cash & Receivables
Total Assets
$827,000
$460,000
Current Liabilities
$100,000
$110,000
Long-Term Debt
400,000
200,000
Common Stock
200,000
140,000
Retained Earnings
127,000
10,000
Total Liabilities & Stockholders’ Equity
$827,000
$460,000
At the date of the business combination, Saloon’s cash and receivables had a fair value of $28,000, inventory had a fair value of $357,000, and buildings and
equipment had a fair value of $92,000.
Required
a.
Give all consolidation entries needed to prepare a consolidated balance sheet on January 1, 20X5.
b.
Complete a consolidated balance sheet worksheet.
c.
Prepare a consolidated balance sheet in good form.
page 175
E4–17
Computation of Consolidated Balances
LO 4–3, 4–5
Single Corporation’s balance sheet at January 1, 20X7, reflected the following balances:
Cash & Receivables
Inventory
$ 80,000
120,000
Land
Buildings & Equipment (net)
Total Assets
Accounts Payable
$ 40,000
Income Taxes Payable
60,000
70,000
Bonds Payable
200,000
480,000
Common Stock
250,000
Retained Earnings
200,000
$750,000
Total Liabilities & Stockholders’ Equity
$750,000
Plural Corporation, which had just entered into an active acquisition program, acquired 100 percent of Single’s common stock on January 2, 20X7, for $576,000. A
careful review of the fair value of Single’s assets and liabilities indicated the following:
Inventory
Land
Buildings & Equipment (net)
Book Value
Fair Value
$120,000
$140,000
70,000
60,000
480,000
550,000
Assume the book values of Plural’s Inventory, Land, and Buildings and Equipment accounts are $300,000, $85,000, and $1,200,000, respectively.
Required
Compute the appropriate amount to be included in the consolidated balance sheet immediately following the acquisition for each of the following items:
a.
Inventory.
b.
Land.
c.
Buildings and Equipment (net).
d.
Goodwill.
e.
Investment in Single Corporation.
E4–18
Multiple-Choice Questions on Balance Sheet Consolidation
LO 4–3
Pocket Corporation acquired 100 percent of Strap Corporation’s common stock on December 31, 20X2. Balance sheet data for the two companies immediately
following the acquisition follow:
Item
Pocket
Corporation
Strap
Corporation
Cash
$ 49,000
$ 30,000
Accounts Receivable
110,000
45,000
Inventory
130,000
70,000
Land
Buildings & Equipment
Less: Accumulated Depreciation
Investment in Strap Corporation Stock
80,000
25,000
500,000
400,000
(223,000)
(165,000)
198,000
Total Assets
$844,000
$405,000
Accounts Payable
$ 61,500
$ 28,000
Taxes Payable
95,000
37,000
Bonds Payable
280,000
200,000
Common Stock
150,000
50,000
Retained Earnings
257,500
90,000
$844,000
$405,000
Total Liabilities & Stockholders’ Equity
page 176
At the date of the business combination, the book values of Strap’s net assets and liabilities approximated fair value except for inventory, which had a fair value of
$85,000, and land, which had a fair value of $45,000.
Required
For each question, indicate the appropriate total that should appear in the consolidated balance sheet prepared immediately after the business combination.
1. What amount of inventory will be reported?
a. $70,000
b. $130,000
c. $200,000
d. $215,000
2. What amount of goodwill will be reported?
a. $0
b. $23,000
c. $43,000
d. $58,000
3. What amount of total assets will be reported?
a. $84,400
b. $1,051,000
c. $1,109,000
d. $1,249,000
4. What amount of total liabilities will be reported?
a. $265,000
b. $436,500
c. $701,500
d. $1,249,000
5. What amount of consolidated retained earnings will be reported?
a. $547,500
b. $397,500
c. $347,500
d. $257,500
6. What amount of total stockholders’ equity will be reported?
a. $407,500
b. $547,500
c. $844,000
d. $1,249,000
E4–19
Wholly Owned Subsidiary with Differential
LO 4–3
Stick Corporation is a wholly owned subsidiary of Point Corporation. Point acquired ownership of Stick on January 1, 20X3, for $28,000 above Stick’s reported net
assets. At that date, Stick reported common stock outstanding of $60,000 and retained earnings of $90,000. The differential is assigned to equipment with an
economic life of seven years at the date of the business combination. Stick reported net income of $30,000 and paid dividends of $12,000 in 20X3.
Required
a.
Give the journal entries recorded by Point Corporation during 20X3 on its books if Point accounts for its investment in Stick using the equity method.
b.
Give the consolidation entries needed at December 31, 20X3, to prepare consolidated financial statements.
page 177
E4–20
Basic Consolidation Worksheet
LO 4–5
Police Corporation acquired 100 percent of Station Corporation’s voting shares on January 1, 20X3, at underlying book value. At that date, the book values and fair
values of Station’s assets and liabilities were equal. Police uses the equity method in accounting for its investment in Station. Adjusted trial balances for Police and
Station on December 31, 20X3, are as follows:
Required
a.
Give all consolidation entries required on December 31, 20X3, to prepare consolidated financial statements.
b.
Prepare a three-part consolidation worksheet as of December 31, 20X3.
E4–21
Basic Consolidation Worksheet for Second Year
LO 4–5
Police Corporation acquired 100 percent of Station Corporation’s voting shares on January 1, 20X3, at underlying book value. At that date, the book values and fair
values of Station’s assets and liabilities were equal. Police uses the equity method in accounting for its investment in Station. Adjusted trial balances for Police and
Station on December 31, 20X4, are as follows:
Required
a.
Give all consolidation entries required on December 31, 20X4, to prepare consolidated financial statements.
b.
Prepare a three-part consolidation worksheet as of December 31, 20X4.
page 178
E4–22
Consolidation Worksheet with Differential
LO 4–5
Pony Corporation acquired all of Stallion Company’s common shares on January 1, 20X5, for $180,000. On that date, the book value of the net assets reported by
Stallion was $150,000. The entire differential was assigned to depreciable assets with a six-year remaining economic life from January 1, 20X5.
The adjusted trial balances for the two companies on December 31, 20X5, are as follows:
Pony uses the equity method in accounting for its investment in Stallion. Stallion declared and paid dividends on December 31, 20X5.
Required
a.
Prepare the consolidation entries needed as of December 31, 20X5, to complete a consolidation worksheet.
b.
Prepare a three-part consolidation worksheet as of December 31, 20X5.
E4–23
Consolidation Worksheet for Subsidiary
LO 4–5
Polka Corporation acquired 100 percent of Song Company’s voting stock on January 1, 20X4, at underlying book value. Polka uses the equity method in accounting
for its ownership of Song. On December 31, 20X4, the trial balances of the two companies are as follows:
page 179
Required
a.
Give all consolidation entries required on December 31, 20X4, to prepare consolidated financial statements.
b.
Prepare a three-part consolidation worksheet as of December 31, 20X4.
E4–24A
Push-Down Accounting
LO 4–7
Pop Company acquired all of Soda Corporation’s common shares on January 2, 20X3, for $789,000. At the date of combination, Soda’s balance sheet appeared as
follows:
Assets
Cash & Receivables
Inventory
Land
Liabilities
$ 34,000
165,000
60,000
Current Payables
Notes Payable
$ 25,000
100,000
Stockholders’ Equity
Buildings (net)
250,000
Common Stock
200,000
Equipment (net)
320,000
Additional Capital
425,000
Retained Earnings
79,000
Total
$829,000
Total
$829,000
The fair values of all of Soda’s assets and liabilities were equal to their book values except for its fixed assets. Soda’s land had a fair value of $75,000; the buildings
had a fair value of $300,000; and the equipment had a fair value of $340,000.
Pop Company decided to employ push-down accounting for the acquisition of Soda Corporation. Subsequent to the combination, Soda continued to operate as
a separate company.
Required
a.
Record the acquisition of Soda’s stock on Pop’s books.
b.
Present any entries that would be made on Soda’s books related to the business combination, assuming push-down accounting is used.
c.
Present, in general journal form, all consolidation entries that would appear in a consolidation worksheet for Pop Company and its subsidiary prepared
immediately following the combination.
PROBLEMS
P4–25
Assignment of Differential in Worksheet
LO 4–5
Pork Corporation acquired all the voting shares of Swine Enterprises on January 1, 20X4. Balance sheet amounts for the companies on the date of acquisition were
as follows:
Pork
Corporation
Swine
Enterprises
$ 40,000
$ 20,000
Inventory
95,000
40,000
Land
80,000
90,000
Buildings & Equipment
400,000
230,000
Investment in Swine Enterprises
290,000
Cash & Receivables
Total Debits
$905,000
$380,000
Accumulated Depreciation
$175,000
$ 65,000
60,000
15,000
Notes Payable
100,000
50,000
Common Stock
300,000
100,000
Retained Earnings
270,000
150,000
$905,000
$380,000
Accounts Payable
Total Credits
page 180
Swine Enterprises’ buildings and equipment were estimated to have a market value of $175,000 on January 1, 20X4. All other items appeared to have market values
approximating current book values.
Required
a.
Complete a consolidated balance sheet worksheet for January 1, 20X4.
b.
Prepare a consolidated balance sheet in good form.
P4–26
Computation of Consolidated Balances
LO 4–3
Post Records Inc. acquired all of Script Studios’ voting shares on January 1, 20X2, for $280,000. Post’s balance sheet immediately after the combination contained
the following balances:
POST RECORDS INC.
Balance Sheet
January 1, 20X2
Cash & Receivables
Inventory
$120,000
Accounts Payable
$ 75,000
110,000
Taxes Payable
50,000
70,000
Notes Payable
300,000
Buildings & Equipment (net)
350,000
Common Stock
400,000
Investment in Script Studios
280,000
Retained Earnings
105,000
Land
Total Assets
$930,000
Total Liabilities & Stockholders’ Equity
Script Studios’ balance sheet at acquisition contained the following balances:
SCRIPT STUDIOS
Balance Sheet
January 1, 20X2
$930,000
Cash & Receivables
$
40,000
Accounts Payable
$
90,000
Inventory
180,000
Notes Payable
250,000
Buildings & Equipment (net)
350,000
Common Stock
100,000
Additional Paid-In Capital
200,000
Retained Earnings
(40,000)
Goodwill
30,000
Total Assets
$ 600,000
Total Liabilities & Stockholders’ Equity
$600,000
On the date of combination, the inventory held by Script had a fair value of $170,000, and its buildings and recording equipment had a fair value of $375,000.
Goodwill reported by Script resulted from a purchase of Sound Stage Enterprises in 20X1. Sound Stage was liquidated and its assets and liabilities were brought
onto Script’s books.
Required
Compute the balances to be reported in the consolidated balance sheet immediately after the acquisition for:
a.
Inventory.
b.
Buildings and Equipment (net).
c.
Investment in Script Stock.
d.
Goodwill.
e.
Common Stock.
f.
Retained Earnings.
P4–27
Balance Sheet Consolidation [AICPA Adapted]
LO 4–5
Pot Inc. acquired all Seed Inc.’s outstanding $25 par common stock on December 31, 20X3, in exchange for 40,000 shares of its $25 par common stock. Pot’s common
stock closed at $56.50 per share on a national stock exchange on December 31, 20X3. Both corporations continued to operate as separate businesses page 181
maintaining separate accounting records with years ending December 31.
On December 31, 20X4, after year-end adjustments and the closing of nominal accounts, the companies had condensed balance sheet accounts (below).
Additional Information
1. Pot uses the equity method of accounting for its investment in Seed.
2. On December 31, 20X3, Seed’s assets and liabilities had fair values equal to the book balances with the exception of land, which had a fair value of $550,000.
Seed had no land transactions in 20X4.
3. On June 15, 20X4, Seed paid a cash dividend of $4 per share on its common stock.
4. On December 10, 20X4, Pot paid a cash dividend totaling $256,000 on its common stock.
5. On December 31, 20X3, immediately before the combination, the stockholders’ equity balance was:
Pot Inc.
Common Stock
Additional Paid-In Capital
Retained Earnings
Seed Inc.
$2,200,000
$1,000,000
840,000
190,000
3,166,000
820,000
$6,206,000
$2,010,000
6. The 20X4 net income amounts according to the separate books of Pot and Seed were $890,000 (exclusive of equity in Seed’s earnings) and $580,000,
respectively.
Pot Inc.
Seed Inc.
Assets
Cash
$
825,000
$
330,000
Accounts & Other Receivables
2,140,000
835,000
Inventories
2,310,000
1,045,000
Land
650,000
300,000
Depreciable Assets (net)
4,575,000
1,980,000
Investment in Seed Inc.
2,680,000
Long-Term Investments & Other Assets
Total Assets
865,000
385,000
$14,045,000
$4,875,000
Liabilities & Stockholders’ Equity
Accounts Payable & Other Current Liabilities
$ 2,465,000
$1,145,000
Long-Term Debt
1,900,000
1,300,000
Common Stock, $25 Par Value
3,200,000
1,000,000
Additional Paid-In Capital
2,100,000
190,000
Retained Earnings
Total Liabilities & Stockholders’ Equity
4,380,000
1,240,000
$14,045,000
$4,875,000
Required
Prepare a consolidated balance sheet worksheet for Pot and its subsidiary, Seed, for December 31, 20X4. A formal consolidated balance sheet is not required.
page 182
P4–28
Consolidated Balance Sheet
LO 4–5
Powder Company spent $240,000 to acquire all of Sawmill Corporation’s stock on January 1, 20X2. The balance sheets of the two companies on December 31, 20X3,
showed the following amounts:
Powder
Company
Cash
Accounts Receivable
Land
Buildings & Equipment
Less: Accumulated Depreciation
Investment in Sawmill Corporation
Sawmill
Corporation
$ 30,000
$ 20,000
100,000
40,000
60,000
50,000
500,000
350,000
(230,000)
(75,000)
252,000
$712,000
$385,000
$ 80,000
$ 10,000
Taxes Payable
40,000
70,000
Notes Payable
100,000
85,000
Common Stock
200,000
100,000
Retained Earnings
292,000
120,000
$712,000
$385,000
Accounts Payable
Sawmill reported retained earnings of $100,000 at the date of acquisition. The difference between the acquisition price and underlying book value is assigned to
buildings and equipment with a remaining economic life of 10 years from the date of acquisition. Assume Sawmill’s accumulated depreciation on the acquisition date
was $25,000.
Required
a.
Give the appropriate consolidation entry or entries needed to prepare a consolidated balance sheet as of December 31, 20X3.
b.
Prepare a consolidated balance sheet worksheet as of December 31, 20X3.
P4–29
Comprehensive Problem: Consolidation in Subsequent Period
LO 4–5, 4–6
Powder Company spent $240,000 to acquire all of Sawmill Corporation’s stock on January 1, 20X2. On December 31, 20X4, the trial balances of the two companies
were as follows:
page 183
Sawmill Corporation reported retained earnings of $100,000 at the date of acquisition. The difference between the acquisition price and underlying book value is
assigned to buildings and equipment with a remaining economic life of 10 years from the date of acquisition. Sawmill’s accumulated depreciation on the acquisition
date was $25,000. At December 31, 20X4, Sawmill owed Powder $2,500.
Required
a.
Give all journal entries recorded by Powder with regard to its investment in Sawmill during 20X4.
b.
Give all consolidation entries required on December 31, 20X4, to prepare consolidated financial statements.
c.
Prepare a three-part consolidation worksheet as of December 31, 20X4.
P4–30
Acquisition at Other than Fair Value of Net Assets
LO 4–3, 4–4
Power Corporation acquired 100 percent ownership of Scrub Company on February 12, 20X9. At the date of acquisition, Scrub Company reported assets and
liabilities with book values of $420,000 and $165,000, respectively, common stock outstanding of $80,000, and retained earnings of $175,000. The book values and fair
values of Scrub’s assets and liabilities were identical except for land, which had increased in value by $20,000, and inventories, which had decreased by $7,000.
Required
Give the consolidation entries required to prepare a consolidated balance sheet immediately after the business combination assuming Power acquired its ownership
of Scrub for
a.
$280,000.
b.
$251,000.
P4–31
Intercorporate Receivables and Payables
LO 4–5, 4–6
Pretzel Corporation acquired 100 percent of Stick Company’s outstanding shares on January 1, 20X7. Balance sheet data for the two companies immediately after the
purchase follow:
Pretzel
Corporation
Stick
Company
$ 70,000
$ 35,000
Accounts Receivable
90,000
65,000
Inventory
84,000
80,000
Cash
Buildings & Equipment
400,000
300,000
Less: Accumulated Depreciation
(160,000)
(75,000)
Investment in Stick Company
305,000
Investment in Stick Company Bonds
50,000
Total Assets
$839,000
$405,000
50,000
$ 20,000
Bonds Payable
200,000
100,000
Common Stock
300,000
150,000
Accounts Payable
$
Capital in Excess of Par
Retained Earnings
Total Liabilities & Equities
140,000
289,000
$839,000
(5,000)
$405,000
As indicated in the parent company balance sheet, Pretzel purchased $50,000 of Stick’s bonds from the subsidiary at par value immediately after it acquired the
stock. An analysis of intercompany receivables and payables also indicates that the subsidiary owes the parent $10,000. On the date of combination, the book
values and fair values of Stick’s assets and liabilities were the same.
page 184
Required
a.
Give all consolidation entries needed to prepare a consolidated balance sheet for January 1, 20X7.
b.
Complete a consolidated balance sheet worksheet.
c.
Prepare a consolidated balance sheet in good form.
P4–32
Balance Sheet Consolidation
LO 4–5
On January 2, 20X8, Primary Corporation acquired 100 percent of Secondary Company’s outstanding common stock. In exchange for Secondary’s stock, Primary
issued bonds payable with a par and fair value of $650,000 directly to the selling stockholders of Secondary. The two companies continued to operate as separate
entities subsequent to combination.
Immediately prior to the combination, the book values and fair values of the companies’ assets and liabilities were as follows:
At the date of combination, Secondary owed Primary $6,000 plus accrued interest of $500 on a short-term note. Both companies have properly recorded these
amounts.
Required
a.
Record the business combination on the books of Primary Corporation.
b.
Present in general journal form all consolidation entries needed in a worksheet to prepare a consolidated balance sheet immediately following the business
combination on January 2, 20X8.
c.
Prepare and complete a consolidated balance sheet worksheet as of January 2, 20X8, immediately following the business combination.
d.
Present a consolidated balance sheet for Primary and its subsidiary as of January 2, 20X8.
P4–33
Consolidation Worksheet at End of First Year of Ownership
LO 4–5
Price Corporation acquired 100 percent ownership of Saver Company on January 1, 20X8, for $128,000. At that date, the fair value of Saver’s buildings and
equipment was $20,000 more than the book value. Buildings and equipment are depreciated on a 10-year basis. Although goodwill is not amortized, Price’s
management concluded at December 31, 20X8, that goodwill involved in its acquisition of Saver shares had been impaired and the correct carrying value was $2,500.
page 185
Trial balance data for Price and Saver on December 31, 20X8, are as follows:
Required
a.
Give all consolidation entries needed to prepare a three-part consolidation worksheet as of December 31, 20X8.
b.
Prepare a three-part consolidation worksheet for 20X8 in good form.
P4–34
Consolidation Worksheet at End of Second Year of Ownership
LO 4–5
Price Corporation acquired 100 percent ownership of Saver Company on January 1, 20X8, for $128,000. At that date, the fair value of Saver’s buildings and
equipment was $20,000 more than the book value. Buildings and equipment are depreciated on a 10-year basis. Although goodwill is not amortized, Price’s
management concluded at December 31, 20X8, that goodwill involved in its acquisition of Saver shares had been impaired and the correct carrying value was $2,500.
No additional impairment occurred in 20X9.
Trial balance data for Price and Saver on December 31, 20X9, are as follows:
page 186
Required
a.
Give all consolidation entries needed to prepare a three-part consolidation worksheet as of December 31, 20X9.
b.
Prepare a three-part consolidation worksheet for 20X9 in good form.
c.
Prepare a consolidated balance sheet, income statement, and retained earnings statement for 20X9.
P4–35
Comprehensive Problem: Wholly Owned Subsidiary
LO 4–5
Prime Corporation acquired 100 percent ownership of Steak Products Company on January 1, 20X1, for $200,000. On that date, Steak reported retained earnings of
$50,000 and had $100,000 of common stock outstanding. Prime has used the equity method in accounting for its investment in Steak.
The trial balances for the two companies on December 31, 20X5, appear below.
Additional Information
1. On the date of combination (five years ago), the fair value of Steak’s depreciable assets was $50,000 more than the book value. Accumulated depreciation at
that date was $10,000. The differential assigned to depreciable assets should be written off over the following 10-year period.
2. There was $10,000 of intercorporate receivables and payables at the end of 20X5.
Required
a.
Give all journal entries that Prime recorded during 20X5 related to its investment in Steak.
b.
Give all consolidation entries needed to prepare consolidated statements for 20X5.
c.
Prepare a three-part worksheet as of December 31, 20X5.
page 187
P4–36
Comprehensive Problem: Differential Apportionment
LO 4–5
Prince Corporation acquired 100 percent of Sword Company on January 1, 20X7, for $203,000. The trial balances for the two companies on December 31, 20X7,
included the following amounts:
Additional Information
1. On January 1, 20X7, Sword reported net assets with a book value of $150,000. A total of $20,000 of the acquisition price is applied to goodwill, which was not
impaired in 20X7.
2. Sword’s depreciable assets had an estimated economic life of 11 years on the date of combination. The difference between fair value and book value of tangible
assets is related entirely to buildings and equipment.
3. Prince used the equity method in accounting for its investment in Sword.
4. Detailed analysis of receivables and payables showed that Sword owed Prince $16,000 on December 31, 20X7.
Required
a.
Give all journal entries recorded by Prince with regard to its investment in Sword during 20X7.
b.
Give all consolidation entries needed to prepare a full set of consolidated financial statements for 20X7.
c.
Prepare a three-part consolidation worksheet as of December 31, 20X7.
P4–37A
Push-Down Accounting
LO 4–7
On December 31, 20X6, Print Corporation and Size Company entered into a business combination in which Print acquired all of Size’s common stock for $935,000. At
the date of combination, Size had common stock outstanding with a par value of $100,000, additional paid-in capital of $400,000, and retained earnings of $175,000.
The fair values and book values of all Size’s assets and liabilities were equal at the date of combination, except for the following:
Book Value
Inventory
Land
$
50,000
Fair Value
$
55,000
75,000
160,000
Buildings
400,000
500,000
Equipment
500,000
570,000
“A” indicates that the item relates to Appendix 4A.
page 188
The buildings had a remaining life of 20 years, and the equipment was expected to last another 10 years. In accounting for the business combination, Print
decided to use push-down accounting on Size’s books.
During 20X7, Size earned net income of $88,000 and paid a dividend of $50,000. All of the inventory on hand at the end of 20X6 was sold during 20X7. During
20X8, Size earned net income of $90,000 and paid a dividend of $50,000.
Required
a.
Record the acquisition of Size’s stock on Print’s books on December 31, 20X6.
b.
Record any entries that would be made on December 31, 20X6, on Size’s books related to the business combination if push-down accounting is employed.
c.
Present all consolidation entries that would appear in the worksheet to prepare a consolidated balance sheet immediately after the combination.
d.
Present all entries that Print would record during 20X7 related to its investment in Size if Print uses the equity method of accounting for its investment.
e.
Present all consolidation entries that would appear in the worksheet to prepare a full set of consolidated financial statements for the year 20X7.
f.
Present all consolidation entries that would appear in the worksheet to prepare a full set of consolidated financial statements for the year 20X8.
1
https://thewaltdisneycompany.com/the-walt-disney-company-acquires-minority-stake-in-bamtech/
2
To view a video explanation of this topic, visit advancedstudyguide.com.
3
Alternatively, a separate clearing account titled “Excess of Acquisition Consideration over Acquiree Book
Value” or just “Differential” can be debited for this excess amount. A subsequent entry can be used to
reclassify the differential to the various accounts on the balance sheet that need to be revalued to their
acquisition date amounts. Note that the Differential account is simply a worksheet clearing account and is
not found on the books of the parent or subsidiary and does not appear in the consolidated financial
statements.
*
The Walt Disney Company, “Disney to Acquire Lucasfilm LTD.” October 30, 2012,
http://thewaltdisneycompany.com/disney-news/press-releases/2012/10/disney-acquire-lucasfilm-ltd.
page 189
5
Consolidation of Less-than-WhollyOwned Subsidiaries Acquired at More
than Book Value
Multicorporate Entities
Business Combinations
Consolidation Concepts and Procedures
Intercompany Transfers
Additional Consolidation Issues
Multinational Entities
Reporting Requirements
Partnerships
Governmental and Not-for-Profit Entities
Corporations in Financial Difficulty
WALMART ACQUIRES A CONTROLLING INTEREST IN MASSMART
In many of the examples of corporate acquisitions discussed so far, the acquiring company has purchased 100 percent of the outstanding stock of the
acquired company. However, the buyer doesn’t always acquire 100 percent ownership of the target company. For example, in 2011, Walmart acquired a 51
percent interest in Massmart, a South African retailer with approximately 290 stores throughout 13 countries, in order to take advantage of Massmart’s
locations. With this purchase, Walmart was able to rapidly enter the sub-Saharan African market. Individual investors still held the remaining 49 percent of
the company. Walmart paid $2.5 billion for the controlling interest. The assets acquired were $6.9 billion, including $3.1 billion in goodwill; liabilities assumed
were $2.4 billion; and the nonredeemable noncontrolling interest was $2.0 billion. 1
Accounting for this type of investment can be very complicated. First, Walmart’s investment of $2.5 billion was not intended solely to purchase
Massmart’s tangible assets. Walmart also paid for Massmart’s potential future earnings capability, its brand recognition, and for the fair value (FV) of assets
in excess of their book values as of the acquisition date. Because Walmart did not purchase 100 percent of Massmart, the Walmart consolidated financial
statements in future years will have to account for the portion of the company owned by the noncontrolling interest (NCI) shareholders. This chapter
explores the consolidation of less-than-wholly-owned subsidiaries when there is a positive differential.
page 190
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO 5–1
Understand and explain how the consolidation process differs when the subsidiary is less-than-wholly-owned and there is a differential.
LO 5–2
Make calculations and prepare consolidation entries for the consolidation of a partially owned subsidiary when there is a complex
positive differential.
LO 5–3
Understand and explain what happens when a parent company ceases to consolidate a subsidiary.
LO 5–4
Make calculations and prepare consolidation entries for the consolidation of a partially owned subsidiary when there is a complex
positive differential and other comprehensive income.
A NONCONTROLLING INTEREST IN CONJUNCTION WITH A DIFFERENTIAL
L O 5 –1
Understand and explain how the consolidation process differs when the subsidiary is less-than-wholly-owned and there is a differential.
This chapter continues to build upon the foundation established in Chapters 2 through 4 related to the consolidation of majority-owned subsidiaries. In fact,
Chapter 5 represents the culmination of our learning process related to procedures associated with the consolidation process. Chapter 5 combines the
complexities introduced in Chapters 3 and 4. Specifically, Chapter 5 examines situations in which the acquiring company purchases less than 100 percent of
the outstanding stock of the acquired company (similar to Chapter 3) and pays an amount higher than its proportionate share of the book value of net assets
(resulting in a differential as introduced in Chapter 4). Once you master Chapter 5, you can handle virtually any consolidation problem!
CONSOLIDATED BALANCE SHEET WITH MAJORITY-OWNED SUBSIDIARY
The consolidation process for a less-than-wholly-owned subsidiary with a differential is the same as the process for a wholly owned subsidiary with a
differential except that the claims of the noncontrolling interest must be considered. The example of Peerless Products Corporation and Special Foods Inc.
from Chapter 4 will serve as a basis for illustrating consolidation procedures when the parent has less than full ownership of a subsidiary. Assume that on
January 1, 20X1, Peerless acquires 80 percent of the common stock of Special Foods for $310,000. At that date, the fair value of the noncontrolling interest
is estimated to be $77,500. The ownership situation can be viewed as follows, when Special Foods’ total fair value is equal to the sum of the fair value of the
consideration given and the fair value of the noncontrolling interest:
page 191
Peerless records the acquisition on its books with the following entry:
(1)
Investment in Special Foods
Cash
310,000
310,000
Record purchase of Special Foods stock.
The balance sheets of Peerless and Special Foods appear immediately after acquisition in Figure 5–1. On the acquisition date, the fair values of all of
Special Foods’ assets and liabilities are equal to their book values except as shown in Figure 5–1.
The excess of the $387,500 total fair value of the consideration given and the noncontrolling interest on the date of combination over the $300,000 book
value of Special Foods is $87,500. Of this total $87,500 differential, $75,000 relates to the excess of the acquisition-date fair value over the book value of
Special Foods’ net identifiable assets, as presented in Figure 5–1. The remaining $12,500 of the differential, the excess of the consideration given and the
noncontrolling interest over the fair value of Special Foods’ net identifiable assets, is assigned to goodwill. Because Peerless acquires only 80 percent of
Special Foods’ outstanding common stock, Peerless’s share of the total differential is $70,000 ($87,500 × 0.80). Specifically, Peerless’s share of the excess
fair value over book value of identifiable net assets (NA) is $60,000 ($75,000 × 0.80) and its share of the goodwill is $10,000 ($12,500 × 0.80). Peerless’s
share of the book value of Special Foods’ net assets is $240,000 [0.80 × (CS $200,000 + RE $100,000)]. As a result, Peerless’s acquisition price of
$310,000 applies to the book value and differential components of Special Foods’ fair value as follows:
F I G U R E 5 –1
Balance Sheets of Peerless Products and Special Foods, January 1, 20X1, Immediately after Combination and Values of Select Assets
of Special Foods
page 192
Assuming that Peerless decides to prepare a consolidated balance sheet on the acquisition date, the book value component of the acquisition price is
divided between Peerless and the noncontrolling interest as follows:
This analysis leads to the following basic consolidation entry:
The basic consolidation entry here is identical to the entry in Chapter 4 with one small exception: the credit to Investment in Special Foods was $300,000
in Chapter 4 when Peerless purchased 100 percent of Special Foods’ common stock. In this example, Peerless purchased only 80 percent of the common
stock, so the $300,000 book value of net assets is shared with the NCI shareholders. The differential can be allocated between Peerless and the
noncontrolling interest as follows:
From this analysis, we can construct the excess value reclassification entry:
Again, this entry is identical to the one in the 100 percent owned Chapter 4 example except that the credit to Investment in Special Foods from the
Chapter 4 example is now shared with the NCI shareholders. As explained in Chapter 4, Special Foods had accumulated depreciation on the acquisition date
of $300,000. The following consolidation entry nets this accumulated depreciation out against the cost of the buildings and equipment.
The combination of these last two consolidation entries makes the buildings and equipment appear as if they were purchased on the acquisition date for
their fair market values and recorded as new assets with zero accumulated depreciation as of that date.
page 193
F I G U R E 5 –2
January 1, 20X1, Worksheet for Consolidated Balance Sheet, Date of Combination; 80 Percent Acquisition at More than Book Value
Figure 5–2 illustrates Peerless’s consolidation worksheet on the date of acquisition at January 1, 20X1. Once the consolidation entries are placed in the
worksheet, each row is summed across to calculate the consolidated totals (the sign impact of debit and credit adjustments must be considered in this
calculation). Note that the asset amounts included in the Consolidated column, and thus in the consolidated balance sheet, consist of book values for
Peerless’s assets and liabilities plus acquisition-date fair values for Special Foods’ assets and liabilities plus goodwill.
CONSOLIDATED FINANCIAL STATEMENTS WITH A MAJORITY-OWNED SUBSIDIARY
L O 5 –2
Make calculations and prepare consolidation entries for the consolidation of a partially owned subsidiary when there is a complex positive
differential.
Consolidation subsequent to acquisition involves the preparation of a complete set of consolidated financial statements, as discussed in Chapter 4. To
continue the illustration from the previous section beyond the date of acquisition, assume Peerless Products and Special Foods report the income and
dividends during 20X1 and 20X2 shown in Figure 5–3. With respect to the assets to which the $87,500 differential relates, assume that the entire inventory is
sold during 20X1, the buildings and equipment have a remaining economic life of 10 years from the date of combination, and Special Foods uses straight-line
depreciation. Furthermore, assume that management determines at the end of 20X1 that the goodwill is impaired and should be written down by $3,125.
Management has determined that the goodwill arising in the acquisition of Special Foods relates proportionately to the controlling and noncontrolling interests,
as does the impairment. Finally, assume that Peerless accounts for its investment in Special Foods using the equity method.
Initial Year of Ownership
The business combination of Peerless Products and Special Foods occurs at the beginning of 20X1. Accordingly, Peerless records the acquisition on January
1, 20X1, as illustrated previously.
page 194
FIGURE 5–3
Income and Dividend Information about Peerless Products and Special Foods for the
Years 20X1 and 20X2
Peerless Products
Special Foods
20X1:
Separate Operating Income, Peerless
$140,000
Net Income, Special Foods
Dividends
$50,000
60,000
30,000
20X2:
Separate Operating Income, Peerless
160,000
Net Income, Special Foods
Dividends
75,000
60,000
40,000
Parent Company Entries
During 20X1, Peerless makes the usual equity-method entries to record income and dividends from its subsidiary (see Figure 5–3). Unlike Chapter 4, because
Peerless purchased only 80 percent of the voting stock, it must share Special Foods’ income and dividends with the subsidiary’s noncontrolling stockholders.
Accordingly, Peerless recognizes only its proportionate share of Special Foods’ net income and dividends. Peerless records the following entries during 20X1:
(2)
Investment in Special Foods
40,000
Income from Special Foods
40,000
Record Peerless’s 80% share of Special Foods’ 20X1 income.
(3)
Cash
24,000
Investment in Special Foods
24,000
Record Peerless’s 80% share of Special Foods’ 20X1 dividend.
In addition, Peerless must write off a portion of the differential with the following entry:
(4)
Income from Special Foods
11,300
Investment in Special Foods
11,300
Record amortization of excess acquisition price.
Special Foods’ undervalued inventory, comprising $5,000 of the total differential, was sold during the year. Therefore, Peerless’s $4,000 portion ($5,000 ×
80%) must be written off by reducing both the investment account and the parent’s income from the subsidiary. Also, Peerless’s portion of the excess fair
value of Special Foods’ buildings and equipment must be amortized at $4,800 per year [($60,000 ÷ 10) × 0.80] over the remaining 10-year life. Finally,
Peerless’s portion of the goodwill impairment, 2,500 ($3,125 × 0.80), is also included in this adjustment. Thus, the entire write-off of the differential is
$11,300 ($4,000 + $4,800 + $2,500). A more detailed calculation of Peerless’s share of the differential amortization is illustrated below in the “Excess Value
(Differential) Calculations.”
The following diagrams illustrate the breakdown of the book value and excess value components of the investment account at the beginning and end of
the year.
page 195
The book value component can be summarized as follows:
The boxed numbers in the chart above comprise the basic consolidation entry:
We then analyze the differential and its changes during the period:
The entire differential amount assigned to the inventory already passed through cost of goods sold during the year. Thus, there is no longer a differential
related to inventory at the end of the year. The only other amortization item is the excess value assigned to the building, amortized over a 10-year period
($60,000 ÷ 10 = $6,000 per year). Finally, the goodwill is deemed to be impaired and worth only $9,375.
Because Peerless’s share of the amortization of the differential was already written off from the investment account against the Income from Special
Foods account on its books, the changes shown in the middle row of this chart are simply reclassified from the Income from Special Foods account to the
various income statement accounts to which they apply using the following worksheet entry:
page 196
Finally, the remaining unamortized differential shown in the bottom row of the Excess Value calculations chart is reclassified to the accounts that need to be
revalued to their amortized acquisition-date fair values:
In sum, these worksheet entries (1) eliminate the balances in the Investment in Special Foods and Income from Special Foods accounts, (2) reclassify the
amortization of excess value to the proper income statement accounts, and (3) reclassify the remaining differential to the appropriate balance sheet accounts
as of the end of the accounting period. The following T-accounts illustrate how Peerless’s equity method investment-related accounts are eliminated.
Again, we repeat the same accumulated depreciation consolidation entry this year (and every year as long as Special Foods owns the assets) that we used
in the initial year.
Consolidation Worksheet—Initial Year of Ownership
After the subsidiary income accruals are entered on Peerless’s books, the adjusted trial balance data of the consolidating companies are entered in the threepart consolidation worksheet as shown in Figure 5–4. The last column in the worksheet will serve as a basis for preparing consolidated financial statements
at the end of 20X1.
Once the appropriate consolidation entries are placed in the consolidation worksheet in Figure 5–4, the worksheet is completed by summing each row
across, taking into consideration the debit or credit effect of the consolidation entries.
Consolidated Net Income and Retained Earnings
As can be seen from the worksheet in Figure 5–4, total consolidated net income for 20X1 is $175,875 and the amount of that income accruing to the
controlling interest, presented as the last number in the income statement section of the worksheet in the Consolidated column, is $168,700. The amount of
retained earnings reported in the consolidated balance sheet at December 31, 20X1, shown as the last number in the retained earnings section of the
worksheet in the Consolidated column, is $408,700. Figure 5–5 illustrates the computation of these amounts.
page 197
F I G U R E 5 –4
December 31, 20X1, Equity-Method Worksheet for Consolidated Financial Statements, Initial Year of Ownership; 80 Percent Acquisition
at More than Book Value
Second Year of Ownership
The equity-method and consolidation procedures employed during the second and subsequent years of ownership are the same as those used during the first
year and are illustrated by continuing the Peerless Products and Special Foods example through 20X2. No further impairment of the goodwill arising from the
business combination occurs in 20X2.
Parent Company Entries
Given the income and dividends as shown in Figure 5–3, Peerless Products records the following entries on its separate books during 20X2:
(5)
Investment in Special Foods
60,000
Income from Special Foods
60,000
Record Peerless’s 80% share of Special Foods’ 20X2 income.
page 198
FIGURE 5–5
Consolidated Net Income and Retained Earnings, 20X1; 80 Percent Acquisition at More
than Book Value
Consolidated net income, 20X1:
Peerless’s separate operating income
$140,000
Special Foods’ net income
50,000
Write-off of differential related to inventory sold in 20X1
(5,000)
Amortization of differential related to buildings and equipment in 20X1
(6,000)
Goodwill impairment loss
(3,125)
Consolidated net income
$175,875
Income to controlling interest, 20X1:
Consolidated net income
$175,875
Income to noncontrolling interest
Income to controlling interest
(7,175)
$168,700
Consolidated retained earnings, December 31, 20X1:
Peerless’s retained earnings on date of combination, January 1, 20X1
Income to controlling interest, 20X1
168,700
Dividends declared by Peerless, 20X1
(60,000)
Consolidated retained earnings
(6)
$300,000
Cash
$408,700
32,000
Investment in Special Foods
32,000
Record Peerless’s 80% share of Special Foods’ 20X2 dividend.
(7)
Income from Special Foods
Investment in Special Foods
4,800
4,800
Record amortization of excess acquisition price.
Consolidation Worksheet—Second Year Following Combination
The consolidation procedures in the second year following the acquisition are very similar to those in the first year. Consistent with the process illustrated in
20X1, we follow the same process for 20X2. In order to determine the worksheet entries for 20X2, we first summarize the changes in the parent’s
investment account during 20X2 as follows:
The book value component can be summarized as follows:
page 199
The boxed numbers in the preceding chart comprise the basic consolidation entry:
The entire differential amount assigned to the inventory already passed through cost of goods sold during the prior year period. The only other amortization
item is the excess value assigned to the building, which continues to be written off over a 10-year period ($60,000 ÷ 10 = $6,000).
Because the amortization of the differential was already written off from the investment account against the Income from Special Foods account, the
change to the differential presented in the middle row of this chart is simply reclassified from the Income from Special Foods account to the income
statement account to which it applies during the consolidation process. Then, the remaining amount of the differential from the last row of this chart is
reclassified to the various balance accounts that need to be revalued to their amortized acquisition-date fair values:
Again, these worksheet entries (1) eliminate the balances in the Investment in Special Foods and Income from Special Foods accounts, (2) reclassify the
amortization of excess value to the proper income statement accounts, and (3) reclassify the remaining differential to the appropriate balance sheet accounts
at the end of the accounting period. The following T-accounts illustrate how Peerless’s Investment in Special Foods and Income from Special Foods
accounts are eliminated.
page 200
Again, we repeat the same accumulated depreciation consolidation entry this year (and every year as long as Special Foods owns the assets) that we used
in the initial year.
Figure 5–6 illustrates the worksheet to prepare a complete set of consolidated financial statements for the year 20X2. Figure 5–7 shows the computation of
20X2 consolidated net income and consolidated retained earnings at the end of 20X2.
Consolidated Financial Statements
Figure 5–8 presents a consolidated income statement and retained earnings statement for the year 20X2 and a consolidated balance sheet as of December 31,
20X2.
DISCONTINUANCE OF CONSOLIDATION
L O 5 –3
Understand and explain what happens when a parent company ceases to consolidate a subsidiary.
A parent that has been consolidating a subsidiary in its financial statements should exclude that company from future consolidation if the parent can no longer
exercise control over it. Control might be lost for a number of reasons, such as (1) the parent sells some or all of its interest in the subsidiary, (2) the
subsidiary issues additional common stock, (3) the parent enters into an agreement to relinquish control, or (4) the subsidiary comes under the control of the
government or other regulator.
If a parent loses control of a subsidiary and no longer holds an equity interest in the former subsidiary, it recognizes a gain or loss for the difference
between any proceeds received from the event leading to loss of control (e.g., sale of interest, expropriation of subsidiary) and the carrying amount of the
parent’s equity interest. If the parent loses control but maintains a noncontrolling equity interest in the former subsidiary, it must recognize a gain or loss for
the difference, at the date control is lost, between (1) the sum of any proceeds received by the parent and the fair value of its remaining equity interest in the
former subsidiary and (2) the carrying amount of the parent’s total interest in the subsidiary.
As an example, assume that Peerless Products sells three-quarters of its 80 percent interest in Special Foods to an unrelated entity on January 1, 20X2,
for $246,000, leaving it holding 20 percent of Special Foods’ outstanding stock. On that date, assume that the fair value of Special Foods as a whole is
$410,000 and the carrying amount of Peerless’s 80 percent share of Special Foods is $314,700 (as shown earlier in the chapter). Assume the fair value of
Peerless’s remaining 20 percent interest in Special Foods is $82,000. Peerless’s gain on the sale of Special Foods stock is computed as follows:
page 201
F I G U R E 5 –6
December 31, 20X2, Equity-Method Worksheet for Consolidated Financial Statements, Second Year of Ownership; 80 Percent Acquisition
at More than Book Value
FIGURE 5–7
Consolidated Net Income and Retained Earnings, 20X2; 80 Percent Acquisition at More
than Book Value
Consolidated net income, 20X2:
Peerless’s separate operating income
$160,000
Special Foods’ net income
75,000
Amortization of differential related to buildings & equipment in 20X2
(6,000)
Consolidated net income
Income to controlling interest, 20X2:
$229,000
Consolidated net income
$229,000
Income to noncontrolling interest
(13,800)
Income to controlling interest
$215,200
Consolidated retained earnings, December 31, 20X2:
Peerless’s retained earnings on date of combination, January 1, 20X1
$300,000
Income to controlling interest, 20X1
168,700
Dividends declared by Peerless, 20X1
(60,000)
Consolidated retained earnings, December 31, 20X1
$408,700
Income to controlling interest, 20X2
215,200
Dividends declared by Peerless, 20X2
(60,000)
Consolidated retained earnings, December 31, 20X2
$563,900
page 202
F I G U R E 5 –8
Consolidated Financial Statements for Peerless Products Corporation and Special Foods Inc., 20X2
Cash proceeds received
Fair value of Peerless’s remaining equity interest in Special Foods
$246,000
82,000
$328,000
Peerless’s total interest in Special Foods at date of sale
Gain on sale of 60 percent interest in Special Foods
314,700
$ 13,300
Peerless reports the $13,300 gain in 20X2 income as follows:
(8)
Cash
246,000
Investment in Special Foods Stock
232,700
Gain on sale of investment.
13,300
Record the sale of 75% of the investment in Special Foods Stock.
page 203
Note that because Peerless no longer has a significant influence, the investment will be accounted for using the cost basis ($82,000) going forward. 3
TREATMENT OF OTHER COMPREHENSIVE INCOME
L O 5 –4
Make calculations and prepare consolidation entries for the consolidation of a partially owned subsidiary when there is a complex positive
differential and other comprehensive income.
ASC 220 requires that companies separately report other comprehensive income (OCI), which includes all revenues, expenses, gains, and losses that under
generally accepted accounting principles are excluded from net income. 4 Comprehensive income is the sum of net income and other comprehensive income.
ASC 220 permits several different options for reporting comprehensive income, but the consolidation process is the same regardless of the reporting format.
Other comprehensive income accounts are temporary accounts that are closed at the end of each period. However, other comprehensive income
accounts are closed to a special stockholders’ equity account, Accumulated Other Comprehensive Income (AOCI), not to Retained Earnings as with typical
temporary accounts like revenues and expenses.
Modification of the Consolidation Worksheet
FYI
Levi Strauss & Co. reported a $48.2 million loss in other comprehensive income (OCI) in 2016. The portion
of this loss that accrued to the NCI shareholders was $468,000; the remaining $47.8 million was
attributable to the parent company’s shareholders.
When a parent or subsidiary has recorded other comprehensive income, the consolidation worksheet normally includes an additional section for other
comprehensive income. This section of the worksheet facilitates computation of the amount of other comprehensive income to be reported; the portion, if
any, of other comprehensive income to be assigned to the noncontrolling interest; and the amount of accumulated other comprehensive income to be reported
in the consolidated balance sheet. Although this extra section of the worksheet for comprehensive income could be placed after the income statement section
of the standard worksheet, the format used here is to place it at the bottom of the worksheet after the equity section. If neither the parent nor any subsidiary
reports other comprehensive income, this final section can be omitted from the worksheet.
To illustrate the consolidation process when a subsidiary reports other comprehensive income, assume that during 20X2 Special Foods purchases
$20,000 of call options designated as a cash-flow hedge. By December 31, 20X2, the fair value of the options increases to $30,000. Other than the effects of
accounting for Special Foods’ purchased call options, the financial statement information reported by Peerless Products and Special Foods at December 31,
20X2, is identical to that presented in Figure 5–7.
Adjusting Entry Recorded by Subsidiary
At December 31, 20X2, Special Foods, the subsidiary, recognizes the increase in the fair value of its purchased call options by recording the following
adjusting entry:
(9) Purchased Call Options
Unrealized Gain on Cash Flow Hedge (OCI)
Record the increase in fair value of purchased call options designated as a cash flow
hedge.
10,000
10,000
The unrealized gain is not included in the subsidiary’s net income but is reported by the subsidiary as an element of OCI.
page 204
Adjusting Entry Recorded by Parent Company
In 20X2, Peerless records all its normal entries relating to its investment in Special Foods as if the subsidiary had not reported other comprehensive income.
In addition, at December 31, 20X2, Peerless Products separately recognizes its proportionate share of the subsidiary’s unrealized gain from the increase in
the value of the contracts:
(10) Gain on Hedge Activity
8,000
Other Comprehensive Income from Special Foods
8,000
Record share of the increase in value of purchased call options which are designated as a
cash flow hedge and held by subsidiary.
Consolidation Worksheet—Second Year Following Combination
The worksheet to prepare a complete set of consolidated financial statements for the year 20X2 is illustrated in Figure 5–9. In the worksheet, Peerless’s
balance in the Investment in Special Foods Stock account is more than the balance in Figure 5–6. Specifically, because of the adjusting entry just mentioned,
Peerless’s $8,000 proportionate share of Special Foods’ unrealized gain is included in the separate section of the worksheet for comprehensive income (Other
Comprehensive Income from Subsidiary—Unrealized Gain on Investments). Special Foods’ trial balance has been changed to reflect (1) the reduction in the
cash balance resulting from the investment acquisition, (2) the investment in purchased call options, and (3) an unrealized gain of $10,000 on the options.
Consolidation Procedures
The normal consolidation entries (the basic consolidation entry, the amortized excess cost reclassification entry, the differential reclassification entry, and the
accumulated depreciation consolidation entry) were used in preparing the consolidation worksheet for 20X2 presented in Figure 5–6.
One additional entry is needed for the treatment of the subsidiary’s other comprehensive income. First, the proportionate share of the subsidiary’s other
comprehensive income recorded by the parent in the adjusting entry previously mentioned must be eliminated to avoid double-counting the subsidiary’s other
comprehensive income. Thus, the adjusting entry is reversed in the worksheet. Moreover, a proportionate share of the subsidiary’s other comprehensive
income must be allocated to the noncontrolling interest:
Other Comprehensive Income Entry:
OCI from Special Foods
8,000
OCI to the NCI
2,000
Investment in Special Foods
8,000
NCI in NA of Subsidiary
2,000
The amount of consolidated other comprehensive income reported in the consolidated financial statements is equal to the subsidiary’s $10,000 amount.
The noncontrolling interest’s $2,000 proportionate share of the subsidiary’s other comprehensive income is deducted to arrive at the $8,000 other
comprehensive income allocated to the controlling interest.
Although consolidated net income is the same in Figure 5–9 as in Figure 5–6, the other comprehensive income section of the worksheet in Figure 5–9
gives explicit recognition to the unrealized gain on purchased call options held by Special Foods. This permits recognition in the consolidated financial
statements under any of the alternative formats permitted by the FASB. Note that the Accumulated Other Comprehensive Income row of the balance sheet in
the consolidation worksheet is simply carried up from the last row of the separate Other Comprehensive Income section at the bottom of the worksheet.
page 205
F I G U R E 5 –9
December 31, 20X2, Comprehensive Income Illustration, Second Year of Ownership; 80 Percent Acquisition at More than Book Value
page 206
F I G U R E 5 –1 0
Consolidated Financial Statements for Peerless Products Corporation and Special Foods Inc., 20X2, Including Other Comprehensive
Income
Consolidated financial statements for the other comprehensive income example are presented in Figure 5–10. Note that consolidated other comprehensive
income includes the full $10,000 unrealized gain. The noncontrolling interest’s share, $15,800 ($13,800 income + $2,000 OCI), is then deducted, along with
its share of consolidated net income, to arrive at the consolidated comprehensive income allocated to the controlling interest. The amount of
page 207
other comprehensive income allocated to the controlling interest is carried to the Accumulated Other Comprehensive Income that is reported
in the consolidated balance sheet, and the noncontrolling interest’s share is included in the Noncontrolling Interest amount in the consolidated balance sheet.
The FASB requires that the amount of each other comprehensive income element allocated to the controlling and noncontrolling interests be disclosed in the
consolidated statements or notes.
Consolidation Worksheet—Comprehensive Income in Subsequent Years
Each year following 20X2, Special Foods will adjust the unrealized gain on investments on its books for the change in fair value of the cash flow hedge. For
example, if Special Foods’ call options increased in value by an additional $5,000 during 20X3, Special Foods would increase by $5,000 the carrying amount
of its purchased call options and recognize as an element of 20X3’s other comprehensive income an unrealized gain of $5,000. Under equity-method
recording, Peerless would increase its Investment in Special Foods Stock account and record its $4,000 share of the subsidiary’s other comprehensive
income.
The consolidation entries required to prepare the consolidation worksheet at December 31, 20X3, would include the normal consolidation entries (the
basic consolidation entry, the amortized excess cost reclassification entry, the differential reclassification entry, and the accumulated depreciation
consolidation entry). In addition, the basic consolidation entry would be expanded to eliminate the subsidiary’s $10,000 beginning Accumulated Other
Comprehensive Income balance and to increase the noncontrolling interest by its proportionate share of the subsidiary’s beginning Accumulated Other
Comprehensive Income amount ($10,000 × 0.20). The Other Comprehensive Income consolidation entry allocates the 20X3 other comprehensive income to
the noncontrolling interest:
Other Comprehensive Income Entry:
OCI from Special Foods
4,000
OCI to the NCI
1,000
Investment in Special Foods
4,000
NCI in NA of Subsidiary
1,000
SUMMARY OF KEY CONCEPTS
The procedures and worksheet for consolidating less-than-wholly-owned subsidiaries are the same as discussed in Chapter 4 for wholly owned subsidiaries, with
several modifications. The worksheet consolidation entries are modified to include the noncontrolling shareholders’ claim on the income and assets of the
subsidiary. The noncontrolling interest has a claim on subsidiary assets based on its acquisition-date fair value. If the acquisition-date fair value of the
consideration given in a business combination, plus the fair value of any noncontrolling interest, exceeds the book value of the subsidiary, the difference is referred
to as a differential and increases both the controlling and noncontrolling interests. The subsidiary’s assets and liabilities are valued in consolidation based on their
full acquisition-date fair values, with goodwill recognized at acquisition for the difference between (1) the sum of the fair value of the consideration given in the
combination and the fair value of the noncontrolling interest and (2) the fair value of the subsidiary’s net identifiable assets. Any subsequent write-off of the
differential reduces both the controlling and noncontrolling interests.
Consolidated net income is equal to the parent’s income from its own operations plus the subsidiary’s net income adjusted for any amortization or write-off of
the differential. The amount of consolidated net income attributable to the noncontrolling interest is equal to the noncontrolling interest’s proportionate share of the
subsidiary’s net income less a proportionate share of any differential write-off. The income attributable to the controlling interest is equal to consolidated net
income less the income attributable to the noncontrolling interest.
page 208
A subsidiary’s other comprehensive income for the period must be recognized in consolidated other comprehensive income and allocated between the
controlling and noncontrolling interests. The consolidation worksheet is modified to accommodate the other comprehensive income items by adding a special
section at the bottom.
KEY TERMS
accumulated other comprehensive income (AOCI), 203
comprehensive income, 203
other comprehensive income (OCI), 203
Appendix 5A
Additional Consolidation Details
Chapters 3, 4, and 5 provide a conceptual foundation for preparing consolidated financial statements and a description of the basic procedures used in preparing
consolidated statements. Before moving on to intercompany transactions in Chapters 6 through 8, several additional items should be considered to provide
completeness and clarity.
NEGATIVE RETAINED EARNINGS OF SUBSIDIARY AT ACQUISITION
A parent company may acquire a subsidiary with a negative, or debit, balance in its retained earnings account. An accumulated deficit of a subsidiary at acquisition
causes no special problems in the consolidation process. The basic investment account consolidation entry is the same in the consolidation worksheet except that
the debit balance in the subsidiary’s Retained Earnings account is eliminated with a credit entry. Thus, the basic investment account consolidation entry appears as
follows:
Basic Investment Account Consolidation Entry:
Common Stock
XX
Income from Special Foods
NCI in NI of Special Foods
Retained Earnings (Accumulated deficit)
XX
XX
Dividends Declared
Investment in Special Foods
NCI in NA of Special Foods
XX
XX
XX
XX
OTHER STOCKHOLDERS’ EQUITY ACCOUNTS
The discussion of consolidated statements up to this point has dealt with companies having stockholders’ equity consisting only of retained earnings and a single
class of capital stock issued at par. Typically, companies have more complex stockholders’ equity structures, often including preferred stock and various types of
additional contributed capital. In general, all stockholders’ equity accounts accruing to the common shareholders receive the same treatment as common stock and
are eliminated at the time common stock is eliminated. The treatment of preferred stock in the consolidation process is discussed in Chapter 9.
SUBSIDIARY’S DISPOSAL OF DIFFERENTIAL-RELATED ASSETS
The disposal of an asset usually has income statement implications. If the asset is held by a subsidiary and is one to which a differential is assigned in the
consolidation worksheet, both the parent’s equity-method income and consolidated net income are affected. On the parent’s books, the portion of the differential
included in the subsidiary investment account that relates to the asset sold must be written off by the parent under the equity method as a reduction in both the
income from the subsidiary and the investment account. In consolidation, the portion of the differential related to the asset sold is treated as an adjustment to
consolidated income.
page 209
Inventory
Any inventory-related differential is assigned to inventory for as long as the subsidiary holds the inventory units. In the period in which the inventory units are
sold, the inventory-related differential is assigned to Cost of Goods Sold, as illustrated previously in Figure 5–4.
The inventory costing method used by the subsidiary determines the period in which the differential cost of goods sold is recognized. When the subsidiary
uses FIFO inventory costing, the inventory units on hand on the date of combination are viewed as being the first units sold after the combination. Therefore, the
differential normally is assigned to cost of goods sold in the period immediately after the combination. When the subsidiary uses LIFO inventory costing, the
inventory units on the date of combination are viewed as remaining in the subsidiary’s inventory. Thus, when the subsidiary uses LIFO inventory costing, the
differential is not assigned to cost of goods sold unless the inventory level drops below its level at the date of combination.
Fixed Assets
A differential related to land held by a subsidiary is added to the Land balance in the consolidation worksheet each time a consolidated balance sheet is prepared. If
the subsidiary sells the land to which the differential relates, the differential is treated in the consolidation worksheet as an adjustment to the gain or loss on the sale
of the land in the period of the sale.
To illustrate, assume that on January 1, 20X1, Pluto purchases all the common stock of Star at $10,000 more than book value. All the differential relates to land
that Star had purchased earlier for $25,000. So long as Star continues to hold the land, the $10,000 differential is assigned to Land in the consolidation worksheet. If
Star sells the land to an unrelated company for $40,000, the following entry is recorded on Star’s books:
(11)
Cash
40,000
Land
25,000
Gain on Sale of Land
15,000
Record sale of land.
While a gain of $15,000 is appropriate for Star to report, the accounting basis of the land to the consolidated entity is $35,000 ($25,000 + $10,000). Therefore, the
consolidated enterprise must report a gain of only $5,000. To reduce the $15,000 gain reported by Star to the $5,000 gain that should be reported by the consolidated
entity, the following consolidation entry is included in the worksheet for the year of the sale:
Eliminate Gain on Sale of Land:
Gain on Sale of Land
Income from Star
10,000
10,000
If, instead, Star sells the land for $32,000, the $7,000 ($32,000 – $25,000) gain recorded by Star is eliminated, and a loss of $3,000 ($32,000 – $35,000) is recognized in
the consolidated income statement. The consolidation entry in this case is
Eliminate Gain and Record Loss on Sale of Land:
Gain on Sale of Land
7,000
Loss on Sale of Land
3,000
Income from Star
10,000
When the equity method is used on the parent’s books, the parent must adjust the carrying amount of the investment and its equity-method income in the period of
the sale to write off the differential, as discussed in Chapter 2. Thereafter, the $10,000 differential no longer exists.
The sale of differential-related equipment is treated in the same manner as land except that the amortization for the current and previous periods must be
considered as well as any accumulated depreciation that may have existed at the acquisition date that is being removed from the records. If all of the assets
associated with that accumulated depreciation are sold, there is no need for the optional entry after the sale of those assets.
page 210
QUESTIONS
Q5–1
Where is the balance assigned to the noncontrolling interest reported in the consolidated balance
sheet?
LO 5–1
Q5–2
Why must a noncontrolling interest be reported in the consolidated balance sheet?
LO 5–1
Q5–3
How does the introduction of noncontrolling shareholders change the consolidation worksheet?
LO 5–1
Q5–4
How is the amount assigned to the noncontrolling interest normally determined when a
consolidated balance sheet is prepared immediately after a business combination?
LO 5–1
Q5–5
What portion of consolidated retained earnings is assigned to the noncontrolling interest in the
consolidated balance sheet?
LO 5–2
Q5–6
When majority ownership is acquired, what portion of the fair value of assets held by the
subsidiary at acquisition is reported in the consolidated balance sheet?
LO 5–2
Q5–7
When majority ownership is acquired, what portion of the goodwill reported in the consolidated
balance sheet is assigned to the noncontrolling interest?
LO 5–2
Q5–8
How is the income assigned to the noncontrolling interest normally computed?
LO 5–2
Q5–9
How is income assigned to the noncontrolling interest shown in the consolidation worksheet?
LO 5–2
Q5–10
How are dividends paid by a subsidiary to noncontrolling shareholders treated in the
consolidation worksheet?
LO 5–2
Q5–11
Under what circumstances would a parent company cease consolidation of a subsidiary?
Explain.
LO 5–3
Q5–12
How do other comprehensive income elements reported by a subsidiary affect the consolidated
financial statements?
LO 5–4
Q5–13
What portion of other comprehensive income reported by a subsidiary is included in the
consolidated statement of comprehensive income as accruing to parent company shareholders?
LO 5–4
Q5–14A
What effect does a negative retained earnings balance on the subsidiary’s books have on
consolidation procedures?
Q5–15A
What type of adjustment must be made in the consolidation worksheet if a differential is
assigned to land and the subsidiary disposes of the land in the current period?
CASES
C5–1
Consolidation Worksheet Preparation
LO 5–2
Analysis
The newest clerk in the accounting office recently entered trial balance data for the parent company and its subsidiaries in the company’s consolidation program.
After a few minutes of additional work needed to eliminate the intercompany investment account balances, he expressed his satisfaction at having completed the
consolidation worksheet for 20X5. In reviewing the printout of the consolidation worksheet, other employees raised several questions, and you are asked to
respond.
Required
Indicate whether each of the following questions can be answered by looking at the data in the consolidation worksheet (indicate why or why not):
a.
Is it possible to tell if the parent is using the equity method in recording its ownership of each subsidiary?
b.
Is it possible to tell if the correct amount of consolidated net income has been reported?
c.
One of the employees thought the parent company had paid well above the fair value of net assets for a subsidiary purchased on January 1, 20X5. Is it possible to
tell by reviewing the consolidation worksheet?
d.
Is it possible to determine from the worksheet the percentage ownership of a subsidiary held by the parent?
“A” indicates that the item relates to Appendix 5A.
page 211
C5–2
Consolidated Income Presentation
LO 5–2
Research
Standard Company has a relatively high profit margin on its sales, and Jewel Company has a substantially lower profit margin. Standard holds 55 percent of Jewel’s
common stock and includes Jewel in its consolidated statements. Standard and Jewel reported sales of $100,000 and $60,000, respectively, in 20X4. Sales increased
to $120,000 and $280,000 for the two companies in 20X5. The average profit margins of the two companies remained constant over the two years at 60 percent and 10
percent, respectively.
Standard’s treasurer was aware that the subsidiary was awarded a major new contract in 20X5 and anticipated a substantial increase in net income for the year.
She was disappointed to learn that consolidated net income allocated to the controlling interest had increased by only 38 percent even though sales were 2.5 times
higher than in 20X4. She is not trained in accounting and does not understand the fundamental processes used in preparing Standard’s consolidated income
statement. She does know, however, that the earnings per share figures reported in the consolidated income statement are based on income allocated to the
controlling interest and she wonders why that number isn’t higher.
Required
As a member of the accounting department, you have been asked to prepare a memo to the treasurer explaining how consolidated net income is computed and the
procedures used to allocate income to the parent company and to the subsidiary’s noncontrolling shareholders. Include in your memo citations to or quotations
from the authoritative literature. To assist the treasurer in gaining a better understanding, prepare an analysis showing the income statement amounts actually
reported for 20X4 and 20X5.
C5–3
Pro Rata Consolidation
LO 5–1
Research
Rose Corporation and Krome Company established a joint venture to manufacture components for both companies’ use on January 1, 20X1, and have operated it
quite successfully for the past four years. Rose and Krome both contributed 50 percent of the equity when the joint venture was created. Rose purchases roughly
70 percent of the output of the joint venture and Krome purchases 30 percent. Rose and Krome have equal numbers of representatives on the joint venture’s board
of directors and participate equally in its management. Joint venture profits are distributed at year-end on the basis of total purchases by each company.
Required
Rose has been using the equity method to report its investment in the joint venture; however, Rose’s financial vice president believes that each company should
use pro rata consolidation. As a senior accountant at Rose, you have been asked to prepare a memo discussing those situations in which pro rata consolidation
may be appropriate and to offer your recommendation as to whether Rose should continue to use the equity method or switch to pro rata consolidation. Include in
your memo citations of and quotations from the authoritative literature to support your arguments.
C5–4
Consolidation Procedures
LO 5–1
Communication
A new employee has been given responsibility for preparing the consolidated financial statements of Sample Company. After attempting to work alone for some
time, the employee seeks assistance in gaining a better overall understanding of the way in which the consolidation process works.
Required
You have been asked to provide assistance in explaining the consolidation process.
a.
Why must the consolidation entries be entered in the consolidation worksheet each time consolidated statements are prepared?
b.
How is the beginning-of-period noncontrolling interest balance determined?
c.
How is the end-of-period noncontrolling interest balance determined?
d.
Which of the subsidiary’s account balances must always be eliminated?
e.
Which of the parent company’s account balances must always be eliminated?
page 212
C5–5
Changing Accounting Standards: Monsanto Company
LO 5–1
Research
Monsanto Company, a St. Louis–based company, is a leading provider of agricultural products for farmers. It sells seeds, biotechnology trait products, and
herbicides worldwide.
Required
a.
How did Monsanto Company report its income to noncontrolling (minority) shareholders of consolidated subsidiaries in its 2016 consolidated income statement?
b.
How did Monsanto Company report its subsidiary noncontrolling (minority) interest in its 2016 consolidated balance sheet?
c.
In 2016, Monsanto had several affiliates that were special-purpose or variable interest entities. What level of ownership did Monsanto have in these entities?
Were any of these consolidated? Why?
EXERCISES
E5–1
Multiple-Choice Questions on Consolidation Process
LO 5–1, 5–2
Select the most appropriate answer for each of the following questions.
1. If A Company acquires 80 percent of the stock of B Company on January 1, 20X2, immediately after the
acquisition, which of the following is correct?
a. Consolidated retained earnings will be equal to the combined retained earnings of the two companies.
b. Goodwill will always be reported in the consolidated balance sheet.
c. A Company’s additional paid-in capital may be reduced to permit the carryforward of B Company retained
earnings.
d. Consolidated retained earnings and A Company retained earnings will be the same.
2. Which of the following is correct?
a. The noncontrolling shareholders’ claim on the subsidiary’s net assets is based on the book value of the
subsidiary’s net assets.
b. Only the parent’s portion of the difference between book value and fair value of the subsidiary’s assets is
assigned to those assets.
c. Goodwill represents the difference between the book value of the subsidiary’s net assets and the amount
paid by the parent to buy ownership.
d. Total assets reported by the parent generally will be less than total assets reported on the consolidated
balance sheet.
3. Which of the following statements is correct?
a. Foreign subsidiaries do not need to be consolidated if they are reported as a separate operating group under
segment reporting.
b. Consolidated retained earnings do not include the noncontrolling interest’s claim on the subsidiary’s
retained earnings.
c. The noncontrolling shareholders’ claim should be adjusted for changes in the fair value of the subsidiary
assets but should not include goodwill.
d. Consolidation is expected any time the investor holds significant influence over the investee.
4. [AICPA Adapted] At December 31, 20X9, Grey Inc. owned 90 percent of Winn Corporation, a consolidated
subsidiary, and 20 percent of Carr Corporation, an investee in which Grey cannot exercise significant
influence. On the same date, Grey had receivables of $300,000 from Winn and $200,000 from Carr. In its
December 31, 20X9, consolidated balance sheet, Grey should report accounts receivable from its affiliates
of
a. $500,000.
b. $340,000.
c. $230,000.
d. $200,000.
page 213
E5–2
Multiple-Choice Questions on Consolidation [AICPA Adapted]
LO 5–1, 5–2
Select the correct answer for each of the following questions.
1. A 70 percent owned subsidiary company declares and pays a cash dividend. What effect does the dividend
have on the retained earnings and noncontrolling interest balances in the parent company’s consolidated
balance sheet?
a. No effect on either retained earnings or noncontrolling interest.
b. No effect on retained earnings and a decrease in noncontrolling interest.
c. Decreases in both retained earnings and noncontrolling interest.
d. A decrease in retained earnings and no effect on noncontrolling interest.
2. How is the portion of consolidated earnings to be assigned to the noncontrolling interest in consolidated
financial statements determined?
a. The parent’s net income is subtracted from the subsidiary’s net income to determine the noncontrolling
interest.
b. The subsidiary’s net income is extended to the noncontrolling interest.
c. The amount of the subsidiary’s earnings recognized for consolidation purposes is multiplied by the
noncontrolling interest’s percentage of ownership.
d. The amount of consolidated earnings on the consolidated worksheets is multiplied by the noncontrolling
interest percentage on the balance sheet date.
3. On January 1, 20X5, Post Company acquired an 80 percent investment in Stake Company. The acquisition
cost was equal to Post’s equity in Stake’s net assets at that date. On January 1, 20X5, Post and Stake had
retained earnings of $500,000 and $100,000, respectively. During 20X5, Post had net income of $200,000,
which included its equity in Stake’s earnings, and declared dividends of $50,000; Stake had net income of
$40,000 and declared dividends of $20,000. There were no other intercompany transactions between the
parent and subsidiary. On December 31, 20X5, what should the consolidated retained earnings be?
a. $650,000
b. $666,000
c. $766,000
d. $770,000
Note: Items 4 and 5 are based on the following information:
On January 1, 20X8, Ritt Corporation acquired 80 percent of Shaw Corporation’s $10 par common stock for $956,000. On this date, the fair value of the
noncontrolling interest was $239,000, and the carrying amount of Shaw’s net assets was $1,000,000. The fair values of Shaw’s identifiable assets and liabilities were
the same as their carrying amounts except for plant assets (net) with a remaining life of 20 years, which were $100,000 in excess of the carrying amount. For the year
ended December 31, 20X8, Shaw had net income of $190,000 and paid cash dividends totaling $125,000.
4. In the January 1, 20X8, consolidated balance sheet, the amount of goodwill reported should be
a. $0.
b. $76,000.
c. $95,000.
d. $156,000.
5. In the December 31, 20X8, consolidated balance sheet, the amount of noncontrolling interest reported should
be
a. $200,000.
b. $239,000.
c. $251,000.
d. $252,000.
page 214
E5–3
Consolidation Entries with Differential
LO 5–2
On June 10, 20X8, Private Corporation acquired 60 percent of Secret Company’s common stock. The fair value of the noncontrolling interest was $32,800 on that
date. Summarized balance sheet data for the two companies immediately after the stock purchase are as follows:
Private Corp.
Item
Secret Company
Book Value
Book Value
$ 25,800
$ 5,000
Accounts Receivable
30,000
10,000
10,000
Inventory
80,000
20,000
25,000
Buildings & Equipment (net)
120,000
50,000
70,000
Investment in Secret Company
49,200
Cash
Fair Value
$
5,000
Total
$305,000
$85,000
$110,000
Accounts Payable
$ 25,000
$ 3,000
$
Bonds Payable
150,000
25,000
Common Stock
55,000
20,000
Retained Earnings
75,000
37,000
$305,000
$85,000
Total
3,000
25,000
$ 28,000
Required
a.
Give the consolidation entries required to prepare a consolidated balance sheet immediately after the purchase of Secret Company shares.
b.
Explain how consolidation entries differ from other types of journal entries recorded in the normal course of business.
E5–4
Computation of Consolidated Balances
LO 5–2
Statue Corporation’s balance sheet at January 1, 20X7, reflected the following balances:
Cash & Receivables
Inventory
Land
Buildings & Equipment (net)
Total Assets
$ 80,000
120,000
Accounts Payable
Income Taxes Payable
$ 40,000
60,000
70,000
Bonds Payable
200,000
480,000
Common Stock
250,000
Retained Earnings
200,000
$750,000
Total Liabilities & Stockholders’ Equity
$750,000
Prize Corporation entered into an active acquisition program and acquired 80 percent of Statue’s common stock on January 2, 20X7, for $470,000. The fair value of
the noncontrolling interest at that date was determined to be $117,500. A careful review of the fair value of Statue’s assets and liabilities indicated the following:
Inventory
Land
Book Value
Fair Value
$120,000
$140,000
70,000
60,000
Buildings & Equipment (net)
480,000
550,000
Goodwill is assigned proportionately to Prize and the noncontrolling shareholders.
Required
Compute the appropriate amount related to Statue to be included in the consolidated balance sheet immediately following the acquisition for each of the following
items:
a.
Inventory
b.
Land
c.
Buildings and equipment (net)
d.
Goodwill
e.
Investment in Statue Corporation
f.
Noncontrolling interest
E5–5
page 215
Balance Sheet Worksheet
LO 5–2
Problem Company owns 90 percent of Solution Dairy’s stock. The balance sheets of the two companies immediately after the Solution acquisition showed the
following amounts:
Problem Company
Cash & Receivables
$
Inventory
Solution Dairy
130,000
$
70,000
210,000
90,000
70,000
40,000
Buildings & Equipment (net)
390,000
220,000
Investment in Solution Dairy
270,000
Land
Total Assets
$1,070,000
Current Payables
$
$
80,000
420,000
$
40,000
Long-Term Liabilities
200,000
100,000
Common Stock
400,000
60,000
Retained Earnings
390,000
220,000
Total Liabilities & Stockholders’ Equity
$1,070,000
$
420,000
The fair value of the noncontrolling interest at the date of acquisition was determined to be $30,000. The full amount of the increase over book value is assigned to
land held by Solution. At the date of acquisition, Solution owed Problem $8,000 plus $900 accrued interest. Solution had recorded the accrued interest, but Problem
had not.
Required
Prepare and complete a consolidated balance sheet worksheet.
E5–6
Majority-Owned Subsidiary Acquired at Higher than Book Value
LO 5–2
Professor Corporation acquired 70 percent of Scholar Corporation’s common stock on December 31, 20X4, for $102,200. The fair value of the noncontrolling interest
at that date was determined to be $43,800. Data from the balance sheets of the two companies included the following amounts as of the date of acquisition:
Item
Professor Corporation
Scholar Corporation
Cash
$ 50,300
$ 21,000
90,000
44,000
130,000
75,000
60,000
30,000
410,000
250,000
(150,000)
(80,000)
Accounts Receivable
Inventory
Land
Buildings & Equipment
Less: Accumulated Depreciation
Investment in Scholar Corporation
102,200
Total Assets
$692,500
$340,000
Accounts Payable
$152,500
$ 35,000
Mortgage Payable
250,000
180,000
80,000
40,000
210,000
85,000
$692,500
$340,000
Common Stock
Retained Earnings
Total Liabilities & Stockholders’ Equity
page 216
At the date of the business combination, the book values of Scholar’s assets and liabilities approximated fair value except for inventory, which had a fair value of
$81,000, and buildings and equipment, which had a fair value of $185,000. At December 31, 20X4, Professor reported accounts payable of $12,500 to Scholar, which
reported an equal amount in its accounts receivable.
Required
a.
Give the consolidation entry or entries needed to prepare a consolidated balance sheet immediately following the business combination.
b.
Prepare a consolidated balance sheet worksheet.
c.
Prepare a consolidated balance sheet in good form.
E5–7
Consolidation with Noncontrolling Interest
LO 5–2
Prophet Corporation acquired 75 percent of Seer Corporation’s voting common stock on December 31, 20X4, for $390,000. At the date of combination, Seer reported
the following:
Current Assets
Long-Term Assets (net)
Total
$220,000
420,000
$640,000
Current Liabilities
$ 80,000
Long-Term Liabilities
200,000
Common Stock
120,000
Retained Earnings
240,000
Total
$640,000
At December 31, 20X4, the book values of Seer’s net assets and liabilities approximated their fair values, except for buildings, which had a fair value of $80,000 more
than book value, and inventories, which had a fair value of $36,000 more than book value. The fair value of the noncontrolling interest was determined to be
$130,000 at that date.
Required
Prophet Corporation wishes to prepare a consolidated balance sheet immediately following the business combination. Give the consolidation entry or entries
needed to prepare a consolidated balance sheet at December 31, 20X4.
E5–8
Multiple-Choice Questions on Balance Sheet Consolidation
LO 5–2
Power Corporation acquired 70 percent of Silk Corporation’s common stock on December 31, 20X2. Balance sheet data for the two companies immediately following
the acquisition follow:
Item
Power Corporation
Silk Corporation
Cash
$ 44,000
$ 30,000
Accounts Receivable
110,000
45,000
Inventory
130,000
70,000
80,000
25,000
500,000
400,000
Less: Accumulated Depreciation
(223,000)
(165,000)
Investment in Silk Corporation
150,500
Land
Buildings & Equipment
Total Assets
$791,500
$405,000
Accounts Payable
$ 61,500
$ 28,000
Taxes Payable
95,000
37,000
Bonds Payable
280,000
200,000
Common Stock
150,000
50,000
Retained Earnings
205,000
90,000
$791,500
$405,000
Total Liabilities & Stockholders’ Equity
page 217
At the date of the business combination, the book values of Silk’s net assets and liabilities approximated fair value except for inventory, which had a fair value of
$85,000, and land, which had a fair value of $45,000. The fair value of the noncontrolling interest was $64,500 on December 31, 20X2.
Required
For each question below, indicate the appropriate total that should appear in the consolidated balance sheet prepared immediately after the business combination.
1. What amount of inventory will be reported?
a. $179,000
b. $200,000
c. $210,500
d. $215,000
2. What amount of goodwill will be reported?
a. $0
b. $28,000
c. $40,000
d. $52,000
3. What amount of total assets will be reported?
a. $1,081,000
b. $1,121,000
c. $1,196,500
d. $1,231,500
4. What amount of total liabilities will be reported?
a. $265,000
b. $436,500
c. $622,000
d. $701,500
5. What amount will be reported as noncontrolling interest?
a. $42,000
b. $52,500
c. $60,900
d. $64,500
6. What amount of consolidated retained earnings will be reported?
a. $295,000
b. $268,000
c. $232,000
d. $205,000
7. What amount of total stockholders’ equity will be reported?
a. $355,000
b. $397,000
c. $419,500
d. $495,000
E5–9
Majority-Owned Subsidiary with Differential
LO 5–2
Server Corporation is a majority-owned subsidiary of Proxy Corporation. Proxy acquired 75 percent ownership on January 1, 20X3, for $133,500. At that date, Server
reported common stock outstanding of $60,000 and retained earnings of $90,000, and the fair value of the noncontrolling interest was $44,500. The differential is
assigned to equipment, which had a fair value $28,000 more than book value and a remaining economic life of seven years at the date of the business combination.
Server reported net income of $30,000 and paid dividends of $12,000 in 20X3.
page 218
Required
a.
Give the journal entries recorded by Proxy during 20X3 on its books if it accounts for its investment in Server using the equity method.
b.
Give the consolidation entries needed at December 31, 20X3, to prepare consolidated financial statements.
E5–10
Differential Assigned to Amortizable Asset
LO 5–1, 5–2
Public Corporation acquired 90 percent of Station Company’s voting common stock on January 1, 20X1, for $486,000. At the time of the combination, Station
reported common stock outstanding of $120,000 and retained earnings of $380,000, and the fair value of the noncontrolling interest was $54,000. The book value of
Station’s net assets approximated market value except for patents that had a market value of $40,000 more than their book value. The patents had a remaining
economic life of five years at the date of the business combination. Station reported net income of $60,000 and paid dividends of $20,000 during 20X1.
Required
a.
What balance did Public report as its investment in Station at December 31, 20X1, assuming Public uses the equity method in accounting for its investment?
b.
Give the consolidation entry or entries needed to prepare consolidated financial statements at December 31, 20X1.
E5–11
Consolidation after One Year of Ownership
LO 5–2
Punk Corporation purchased 80 percent of Soul Corporation’s stock on January 1, 20X2. At that date, Soul reported retained earnings of $80,000 and had $120,000 of
stock outstanding. The fair value of its buildings was $32,000 more than the book value.
Punk paid $190,000 to acquire the Soul shares. At that date, the noncontrolling interest had a fair value of $47,500. The remaining economic life for all Soul’s
depreciable assets was eight years on the date of combination. The amount of the differential assigned to goodwill is not impaired. Soul reported net income of
$40,000 in 20X2 and declared no dividends.
Required
a.
Give the consolidation entries needed to prepare a consolidated balance sheet immediately after Punk purchased Soul stock.
b.
Give all consolidation entries needed to prepare a full set of consolidated financial statements for 20X2.
E5–12
Consolidation Following Three Years of Ownership
LO 5–1, 5–2
Purchase Corporation purchased 60 percent of Steal Company ownership on January 1, 20X7, for $277,500. Steal reported the following net income and dividend
payments:
Year
Net Income
Dividends Paid
20X7
$45,000
$25,000
20X8
55,000
35,000
20X9
30,000
10,000
On January 1, 20X7, Steal had $250,000 of $5 par value common stock outstanding and retained earnings of $150,000, and the fair value of the noncontrolling interest
was $185,000. Steal held land with a book value of $22,500 and a market value of $30,000 and equipment with a book value of $320,000 and a market value of $360,000
at the date of combination. The remainder of the differential at acquisition was attributable to an increase in the value of patents, which had a remaining useful life of
10 years. All depreciable assets held by Steal at the date of acquisition had a remaining economic life of eight years.
Required
a.
Compute the increase in the fair value of patents held by Steal.
b.
Prepare the consolidation entries needed at January 1, 20X7, to prepare a consolidated balance sheet.
c.
Compute the balance reported by Purchase as its investment in Steal at December 31, 20X8.
d.
Prepare the journal entries recorded by Purchase with regard to its investment in Steal during 20X9.
e.
Prepare the consolidation entries needed at December 31, 20X9, to prepare a three-part consolidation worksheet.
E5–13
page 219
Consolidation Worksheet for Majority-Owned Subsidiary
LO 5–2
Proud Corporation acquired 80 percent of Spirited Company’s voting stock on January 1, 20X3, at underlying book value. The fair value of the noncontrolling
interest was equal to 20 percent of the book value of Spirited at that date. Assume that the accumulated depreciation on depreciable assets was $60,000 on the
acquisition date. Proud uses the equity method in accounting for its ownership of Spirited during 20X3. On December 31, 20X3, the trial balances of the two
companies are as follows:
Required
a.
Give all consolidation entries required as of December 31, 20X3, to prepare consolidated financial statements.
b.
Prepare a three-part consolidation worksheet.
c.
Prepare a consolidated balance sheet, income statement, and retained earnings statement for 20X3.
E5–14
Consolidation Worksheet for Majority-Owned Subsidiary for Second Year
LO 5–2
This exercise is a continuation of E5-13. Proud Corporation acquired 80 percent of Spirited Company’s voting stock on January 1, 20X3, at underlying book value.
The fair value of the noncontrolling interest was equal to 20 percent of the book value of Spirited at that date. Assume that the accumulated depreciation on
depreciable assets was $60,000 on the acquisition date. Proud uses the equity method in accounting for its ownership of Spirited. On December 31, 20X4, the trial
balances of the two companies are as follows:
page 220
Required
a.
Give all consolidation entries required on December 31, 20X4, to prepare consolidated financial statements.
b.
Prepare a three-part consolidation worksheet as of December 31, 20X4.
E5–15
Preparation of Stockholders’ Equity Section with Other Comprehensive
Income
LO 5–4
Purple Corporation acquired 75 percent of Socks Corporation’s common stock on January 1, 20X8, for $435,000. At that date, Socks reported common stock
outstanding of $300,000 and retained earnings of $200,000, and the fair value of the noncontrolling interest was $145,000. The book values and fair values of Socks’s
assets and liabilities were equal, except for other intangible assets, which had a fair value $80,000 more than book value and a 10-year remaining life. Purple and
Socks reported the following data for 20X8 and 20X9:
Required
a.
Compute consolidated comprehensive income for 20X8 and 20X9.
b.
Compute comprehensive income attributable to the controlling interest for 20X8 and 20X9.
c.
Assuming that Purple reported capital stock outstanding of $320,000 and retained earnings of $430,000 at January 1, 20X8, prepare the stockholders’ equity
section of the consolidated balance sheet at December 31, 20X8 and 20X9.
E5–16
Consolidation Entries for Subsidiary with Other Comprehensive Income
LO 5–4
Purse Corporation acquired 70 percent of Scarf Corporation’s ownership on January 1, 20X8, for $140,000. At that date, Scarf reported capital stock outstanding of
$120,000 and retained earnings of $80,000, and the fair value of the noncontrolling interest was equal to 30 percent of the book value of Scarf. During 20X8, Scarf
reported net income of $30,000 and comprehensive income of $36,000 and paid dividends of $25,000.
Required
a.
Present all equity-method entries that Purse would have recorded in accounting for its investment in Scarf during 20X8.
b.
Present all consolidation entries needed at December 31, 20X8, to prepare a complete set of consolidated financial statements for Purse Corporation and its
subsidiary.
E5–17A
Consolidation of Subsidiary with Negative Retained Earnings
Putt Corporation acquired 80 percent of Slice Company’s voting common stock on January 1, 20X4, for $138,000. At that date, the fair value of the noncontrolling
interest was $34,500. Slice’s balance sheet at the date of acquisition contained the following balances:
page 221
SLICE COMPANY
Balance Sheet
January 1, 20X4
Cash
$ 20,000
Accounts Payable
$ 35,000
Accounts Receivable
35,000
Notes Payable
180,000
Land
90,000
Common Stock
100,000
Building & Equipment
300,000
Additional Paid-In Capital
Less: Accumulated Depreciation
(85,000)
Retained Earnings
Total Assets
$360,000
Total Liabilities & Stockholders’ Equity
75,000
(30,000)
$360,000
At the date of acquisition, the reported book values of Slice’s assets and liabilities approximated fair value.
Required
Give the consolidation entry or entries needed to prepare a consolidated balance sheet immediately following the business combination.
E5–18A
Complex Assignment of Differential
On December 31, 20X4, Puzzle Corporation acquired 90 percent of Sunday Inc.’s common stock for $864,000. At that date, the fair value of the noncontrolling
interest was $96,000. Of the $240,000 differential, $5,000 related to the increased value of Sunday’s inventory, $75,000 related to the increased value of its land,
$60,000 related to the increased value of its equipment, and $50,000 was associated with a change in the value of its notes payable due to increasing interest rates.
Sunday’s equipment had a remaining life of 15 years from the date of combination. Sunday sold all inventory it held at the end of 20X4 during 20X5; the land to
which the differential related also was sold during the year for a large gain. The amortization of the differential relating to Sunday’s notes payable was $7,500 for
20X5.
At the date of combination, Puzzle reported retained earnings of $120,000, common stock outstanding of $500,000, and premium on common stock of $100,000.
For the year 20X5, it reported net income of $150,000 but paid no dividends. Puzzle accounts for its investment in Sunday using the equity method.
Required
a.
Present all entries that Puzzle would have recorded during 20X5 with respect to its investment in Sunday.
b.
Present all consolidation entries that would have been included in the worksheet to prepare a full set of consolidated financial statements for the year 20X5.
PROBLEMS
P5–19
Reported Balances
LO 5–1
Paint Corporation acquired 80 percent of the stock of Stain Company by issuing shares of its common stock with a fair value of $192,000. At that time, the fair value
of the noncontrolling interest was estimated to be $48,000, and the fair values of Stain’s identifiable assets and liabilities were $310,000 and $95,000, respectively.
Stain’s assets and liabilities had book values of $220,000 and $95,000, respectively.
Required
Compute the following amounts to be reported immediately after the combination
a.
Investment in Stain reported by Paint.
b.
Goodwill for the combined entity.
c.
Noncontrolling interest reported in the consolidated balance sheet.
P5–20
Acquisition Price
LO 5–1
Summer Company holds assets with a fair value of $120,000 and a book value of $90,000 and liabilities with a book value and fair value of $25,000.
page 222
Required
Compute the following amounts if Parade Corporation acquires 60 percent ownership of Summer:
a.
What amount did Parade pay for the shares if no goodwill and no gain on a bargain purchase are reported?
b.
What amount did Parade pay for the shares if the fair value of the noncontrolling interest at acquisition is $54,000 and goodwill of $40,000 is reported?
c.
What balance will be assigned to the noncontrolling interest in the consolidated balance sheet if Parade pays $73,200 to acquire its ownership and goodwill of
$27,000 is reported?
P5–21
Multiple-Choice
Adapted]
Questions
on
Applying
the
Equity
Method
[AICPA
LO 5–1
Select the correct answer for each of the following questions.
1. On July 1, 20X3, Barker Company purchased 20 percent of Acme Company’s outstanding common stock for $400,000 when the fair value of Acme’s net assets
was $2,000,000. Barker does not have the ability to exercise significant influence over Acme’s operating and financial policies. The following data concerning
Acme are available for 20X3:
Net income
Dividends declared and paid
Twelve Months Ended
December 31, 20X3
Six Months Ended
December 31, 20X3
$300,000
$190,000
160,000
100,000
In its income statement for the year ended December 31, 20X3, how much income should Barker report from this investment?
a. $20,000
b. $32,000
c. $38,000
d. $60,000
2. On January 1, 20X3, Miller Company purchased 25 percent of Wall Corporation’s common stock; no differential resulted from the purchase. Miller appropriately
uses the equity method for this investment, and the balance in Miller’s investment account was $190,000 on December 31, 20X3. Wall reported net income of
$120,000 for the year ended December 31, 20X3, and paid dividends on its common stock totaling $48,000 during 20X3. How much did Miller pay for its 25
percent interest in Wall?
a. $172,000
b. $202,000
c. $208,000
d. $232,000
3. On January 1, 20X7, Robohn Company purchased for cash 40 percent of Lowell Company’s 300,000 shares of voting common stock for $1,800,000 when 40
percent of the underlying equity in Lowell’s net assets was $1,740,000. The payment in excess of underlying equity was assigned to amortizable assets with a
remaining life of six years. As a result of this transaction, Robohn has the ability to exercise significant influence over Lowell’s operating and financial policies.
Lowell’s net income for the year ended December 31, 20X7, was $600,000. During 20X7, Lowell paid $325,000 in dividends to its shareholders. The income
reported by Robohn for its investment in Lowell should be
a. $120,000.
b. $130,000.
c. $230,000.
d. $240,000.
4. In January 20X0, Farley Corporation acquired 20 percent of Davis Company’s outstanding common stock for $800,000. This investment gave Farley the ability
to exercise significant influence over Davis. The book value of the acquired shares was $600,000. The excess of cost over book value was attributed to an
identifiable intangible asset, which was undervalued on Davis’s balance sheet and had a remaining economic life of 10 years. For the year ended page 223
December 31, 20X0, Davis reported net income of $180,000 and paid cash dividends of $40,000 on its common stock. What is the proper carrying
value of Farley’s investment in Davis on December 31, 20X0?
a. $772,000
b. $780,000
c. $800,000
d. $808,000
P5–22
Amortization of Differential
LO 5–1
Pawn Corporation purchased 30 percent of Shop Company’s common stock on January 1, 20X5, by issuing preferred stock with a par value of $50,000 and a market
price of $120,000. The following amounts relate to Shop’s balance sheet items at that date:
Cash & Receivables
Buildings & Equipment
Book Value
Fair Value
$200,000
$200,000
400,000
360,000
Less: Accumulated Depreciation
(100,000)
Total Assets
$500,000
Accounts Payable
$50,000
50,000
Bonds Payable
200,000
200,000
Common Stock
100,000
Retained Earnings
150,000
Total Liabilities & Equities
$500,000
Shop purchased buildings and equipment on January 1, 20X0, with an expected economic life of 20 years. No change in overall expected economic life occurred as a
result of the acquisition of Pawn’s stock. The amount paid in excess of the fair value of Shop’s reported net assets is attributed to unrecorded copyrights with a
remaining useful life of eight years. During 20X5, Shop reported net income of $40,000 and paid dividends of $10,000.
Required
Give all journal entries to be recorded on Pawn Corporation’s books during 20X5, assuming it uses the equity method in accounting for its ownership of Shop
Company.
P5–23
Computation of Account Balances
LO 5–1
Pencil Company purchased 40 percent ownership of Stylus Corporation on January 1, 20X1, for $150,000. Stylus’s balance sheet at the time of acquisition was as
follows:
During 20X1 Stylus Corporation reported net income of $30,000 and paid dividends of $9,000. The fair values of Stylus’s assets and liabilities were equal to their
book values at the date of acquisition, with the exception of buildings and equipment, which had a fair value $35,000 above book value. All buildings and page 224
equipment had remaining lives of five years at the time of the business combination. The amount attributed to goodwill as a result of its purchase of
Stylus shares is not impaired.
Required
a.
What amount of investment income will Pencil Company record during 20X1 under equity-method accounting?
b.
What amount of income will be reported under the cost method?
c.
What will be the balance in the investment account on December 31, 20X1, under (1) cost-method and (2) equity-method accounting?
P5–24
Complex Differential
LO 5–1, 5–2
Peace Company issued common shares with a par value of $50,000 and a market value of $165,000 in exchange for 30 percent ownership of Symbol Corporation on
January 1, 20X2. Symbol reported the following balances on that date:
SYMBOL CORPORATION
Balance Sheet January 1, 20X2
Book Value
Fair Value
Assets
Cash
Accounts Receivable
Inventory (FIFO basis)
Land
Buildings & Equipment
Less: Accumulated Depreciation
$ 40,000
$ 40,000
80,000
80,000
120,000
150,000
50,000
65,000
500,000
320,000
(240,000)
Patent
Total Assets
25,000
$550,000
$680,000
$ 30,000
$ 30,000
Bonds Payable
100,000
100,000
Common Stock
150,000
Liabilities & Equities
Accounts Payable
Additional Paid-In Capital
Retained Earnings
Total Liabilities & Equities
20,000
250,000
$550,000
The estimated economic life of the patents held by Symbol is 10 years. The buildings and equipment are expected to last 12 more years on average. Symbol paid
dividends of $9,000 during 20X2 and reported net income of $80,000 for the year.
Required
Compute the amount of investment income (loss) reported by Peace from its investment in Symbol for 20X2 and the balance in the investment account on December
31, 20X2, assuming the equity method is used in accounting for the investment.
P5–25
Equity Entries with Differential
LO 5–1
On January 1, 20X0, Pepper Corporation issued 6,000 of its $10 par value shares to acquire 45 percent of the shares of Salt Manufacturing. Salt Manufacturing’s
balance sheet immediately before the acquisition contained the following items:
SALT MANUFACTURING
Balance Sheet January 1, 20X0
Book Value
Fair Value
$ 30,000
$ 30,000
70,000
80,000
120,000
150,000
80,000
80,000
Assets
Cash & Receivables
Land
Buildings & Equipment (net) page 225
Patent
Total Assets
$300,000
Liabilities & Equities
Accounts Payable
$ 90,000
Common Stock
90,000
150,000
Retained Earnings
60,000
Total Liabilities & Equities
$300,000
On the date of the stock acquisition, Pepper’s shares were selling at $35, and Salt Manufacturing’s buildings and equipment had a remaining economic life of 10
years. The amount of the differential assigned to goodwill is not impaired.
In the two years following the stock acquisition, Salt Manufacturing reported net income of $80,000 and $50,000 and paid dividends of $20,000 and $40,000,
respectively. Pepper used the equity method in accounting for its ownership of Salt Manufacturing.
Required
a.
Give the entry recorded by Pepper Corporation at the time of acquisition.
b.
Give the journal entries recorded by Pepper during 20X0 and 20X1 related to its investment in Salt Manufacturing.
c.
What balance will be reported in Pepper’s investment account on December 31, 20X1?
P5–26
Equity Entries with Differential
LO 5–1
Plug Corporation acquired 35 percent of Spark Corporation’s stock on January 1, 20X8, by issuing 25,000 shares of its $2 par value common stock. Spark
Corporation’s balance sheet immediately before the acquisition contained the following items:
SPARK CORPORATION
Balance Sheet
January 1, 20X8
Book Value
Fair Value
$ 40,000
$ 40,000
Inventory (FIFO basis)
80,000
100,000
Land
50,000
70,000
240,000
320,000
$410,000
$530,000
$ 70,000
$ 70,000
Assets
Cash & Receivables
Buildings & Equipment (net)
Total Assets
Liabilities & Equities
Accounts Payable
Common Stock
130,000
Retained Earnings
210,000
Total Liabilities & Equities
$410,000
Shares of Plug were selling at $8 at the time of the acquisition. On the date of acquisition, the remaining economic life of buildings and equipment held by Spark was
20 years. The amount of the differential assigned to goodwill is not impaired. For the year 20X8, Spark reported net income of $70,000 and paid dividends of $10,000.
Required
a.
Give the journal entries recorded by Plug Corporation during 20X8 related to its investment in Spark Corporation.
b.
What balance will Plug report as its investment in Spark at December 31, 20X8?
page 226
P5–27
Additional Ownership Level
LO 5–1
Balance sheet, income, and dividend data for Amber Corporation, Blair Corporation, and Carmen Corporation at January 1, 20X3, were as follows:
Account Balances
Amber Corporation
Blair Corporation
Carmen Corporation
$ 70,000
$ 60,000
$ 20,000
Accounts Receivable
120,000
80,000
40,000
Inventory
100,000
90,000
65,000
Fixed Assets (net)
450,000
350,000
240,000
Total Assets
$740,000
$580,000
$365,000
Accounts Payable
$105,000
$110,000
$ 45,000
Bonds Payable
300,000
200,000
120,000
Common Stock
150,000
75,000
90,000
Retained Earnings
185,000
195,000
110,000
Total Liabilities & Equity
$740,000
$580,000
$365,000
Income from Operations in 20X3
$220,000
$100,000
Cash
Net Income for 20X3
$ 50,000
Dividends Declared & Paid
60,000
30,000
25,000
On January 1, 20X3, Amber Corporation purchased 40 percent of the voting common stock of Blair Corporation by issuing common stock with a par value of $40,000
and fair value of $130,000. Immediately after this transaction, Blair purchased 25 percent of the voting common stock of Carmen Corporation by issuing bonds
payable with a par value and market value of $51,500.
On January 1, 20X3, the book values of Blair’s net assets were equal to their fair values except for equipment that had a fair value $30,000 more than book value
and patents that had a fair value $25,000 more than book value. At that date, the equipment had a remaining economic life of eight years, and the patents had a
remaining economic life of five years. The book values of Carmen’s assets were equal to their fair values except for inventory that had a fair value $6,000 in excess of
book value and was accounted for on a FIFO basis.
Required
a.
Compute the net income reported by Amber Corporation for 20X3, assuming Amber and Blair used the equity method in accounting for their intercorporate
investments.
b.
Give all journal entries recorded by Amber relating to its investment in Blair during 20X3.
P5–28
Correction of Error
LO 5–1
Pesto Company paid $164,000 to acquire 40 percent ownership of Sauce Company on January 1, 20X2. Net book value of Sauce’s assets on that date was $300,000.
Book values and fair values of net assets held by Sauce were the same except for equipment and patents. Equipment held by Sauce had a book value of $70,000 and
fair value of $120,000. All of the remaining purchase price was attributable to the increased value of patents with a remaining useful life of eight years. The remaining
economic life of all depreciable assets held by Sauce was five years.
Sauce Company’s net income and dividends for the three years immediately following the purchase of shares were as follows:
Year
Net Income
Dividends
20X2
$40,000
$15,000
20X3
60,000
20,000
20X4
70,000
25,000
page 227
The computation of Pesto’s investment income for 20X4 and entries in its investment account since the date of purchase were as follows:
Before making closing entries at the end of 20X4, Pestos’s new controller reviewed the reports and was convinced that both the balance in the investment account
and the investment income that Sauce reported for 20X4 were in error.
Required
Prepare a correcting entry, along with supporting computations, to properly state the balance in the investment account and all related account balances at the end
of 20X4.
P5–29
Majority-Owned Subsidiary Acquired at More Than Book Value
LO 5–2
Phone Corporation acquired 70 percent of Smart Corporation’s common stock on December 31, 20X4, for $102,200. At that date, the fair value of the noncontrolling
interest was $43,800. Data from the balance sheets of the two companies included the following amounts as of the date of acquisition:
Item
Phone Corporation
Smart Corporation
Cash
$ 50,300
$ 21,000
90,000
44,000
130,000
75,000
60,000
30,000
410,000
250,000
Less: Accumulated Depreciation
(150,000)
(80,000)
Investment in Smart Corporation
102,200
Accounts Receivable
Inventory
Land
Buildings & Equipment
Total Assets
$692,500
$340,000
Accounts Payable
$152,500
$ 35,000
Mortgage Payable
250,000
180,000
80,000
40,000
210,000
85,000
$692,500
$340,000
Common Stock
Retained Earnings
Total Liabilities & Stockholders’ Equity
At the date of the business combination, the book values of Smart’s assets and liabilities approximated fair value except for inventory, which had a fair value of
$81,000, and buildings and equipment, which had a fair value of $185,000. At December 31, 20X4, Phone reported accounts payable of $12,500 to Smart, which
reported an equal amount in its accounts receivable.
page 228
Required
a.
Give the consolidation entry or entries needed to prepare a consolidated balance sheet immediately following the business combination.
b.
Prepare a consolidated balance sheet worksheet.
c.
Prepare a consolidated balance sheet in good form.
P5–30
Balance Sheet Consolidation of Majority-Owned Subsidiary
LO 5–2
On January 2, 20X8, Photo Corporation acquired 75 percent of Shutter Company’s outstanding common stock. In exchange for Shutter’s stock, Photo issued bonds
payable with a par value of $500,000 and fair value of $510,000 directly to the selling stockholders of Shutter. At that date, the fair value of the noncontrolling
interest was $170,000. The two companies continued to operate as separate entities subsequent to the combination.
Immediately prior to the combination, the book values and fair values of the companies’ assets and liabilities were as follows:
At the date of combination, Shutter owed Photo $6,000 plus accrued interest of $500 on a short-term note. Both companies have properly recorded these amounts.
Required
a.
Record the business combination on the books of Photo Corporation.
b.
Present in general journal form all consolidation entries needed in a worksheet to prepare a consolidated balance sheet immediately following the business
combination on January 2, 20X8.
c.
Prepare and complete a consolidated balance sheet worksheet as of January 2, 20X8, immediately following the business combination.
d.
Present a consolidated balance sheet for Photo and for Shutter as of January 2, 20X8.
P5–31
Incomplete Data
LO 5–1, 5–2
Paragraph Corporation acquired controlling ownership of Sentence Corporation on December 31, 20X3, and a consolidated balance sheet was prepared immediately.
Partial balance sheet data for the two companies and the consolidated entity at that date follow:
page 229
During 20X3, Paragraph provided engineering services to Sentence and has not yet been paid for them. There were no other receivables or payables between
Paragraph and Sentence at December 31, 20X3.
Required
a.
What is the amount of unpaid engineering services at December 31, 20X3, on work done by Paragraph for Sentence?
b.
What balance in accounts receivable did Sentence report at December 31, 20X3?
c.
What amounts of wages payable did Paragraph and Sentence report at December 31, 20X3?
d.
What was the fair value of Sentence as a whole at the date of acquisition?
e.
What percentage of Sentence’s shares were purchased by Paragraph?
f.
What amounts of capital stock and retained earnings must be reported in the consolidated balance sheet?
P5–32
Income and Retained Earnings
LO 5–2
Paste Corporation acquired 70 percent of Stick Company’s stock on January 1, 20X9, for $105,000. At that date, the fair value of the noncontrolling interest was
equal to 30 percent of the book value of Stick Company. The companies reported the following stockholders’ equity balances immediately after the acquisition:
Paste Corporation
Stick Company
$120,000
$ 30,000
Additional Paid-In Capital
230,000
80,000
Retained Earnings
290,000
Common Stock
Total
$640,000
40,000
$150,000
Paste and Stick reported 20X9 operating incomes of $90,000 and $35,000 and dividend payments of $30,000 and $10,000, respectively.
Required
a.
Compute the amount reported as net income by each company for 20X9, assuming Paste uses equity-method accounting for its investment in Stick.
b.
Compute consolidated net income for 20X9.
c.
Compute the reported balance in retained earnings at December 31, 20X9, for both companies.
d.
Compute consolidated retained earnings at December 31, 20X9.
e.
How would the computation of consolidated retained earnings at December 31, 20X9, change if Paste uses the cost method in accounting for its investment in
Stick?
P5–33
Consolidation Worksheet at End of First Year of Ownership
LO 5–2
Pie Corporation acquired 75 percent of Slice Company’s ownership on January 1, 20X8, for $96,000. At that date, the fair value of the noncontrolling interest was
$32,000. The book value of Slice’s net assets at acquisition was $100,000. The book values and fair values of Slice’s assets and liabilities were equal, page 230
except for Slice’s buildings and equipment, which were worth $20,000 more than book value. Accumulated depreciation on the buildings and equipment
was $30,000 on the acquisition date. Buildings and equipment are depreciated on a 10-year basis.
Although goodwill is not amortized, the management of Pie concluded at December 31, 20X8, that goodwill from its purchase of Slice shares had been impaired
and the correct carrying amount was $2,500. Goodwill and goodwill impairment were assigned proportionately to the controlling and noncontrolling shareholders.
Trial balance data for Pie and Slice on December 31, 20X8, are as follows:
Required
a.
Give all consolidation entries needed to prepare a three-part consolidation worksheet as of December 31, 20X8.
b.
Prepare a three-part consolidation worksheet for 20X8 in good form.
P5–34
Consolidation Worksheet at End of Second Year of Ownership
LO 5–2
This problem is a continuation of P5-33. Pie Corporation acquired 75 percent of Slice Company’s ownership on January 1, 20X8, for $96,000. At that date, the fair
value of the noncontrolling interest was $32,000. The book value of Slice’s net assets at acquisition was $100,000. The book values and fair values of Slice’s assets
and liabilities were equal, except for Slice’s buildings and equipment, which were worth $20,000 more than book value. Accumulated depreciation on the buildings
and equipment was $30,000 on the acquisition date. Buildings and equipment are depreciated on a 10-year basis.
Although goodwill is not amortized, the management of Pie concluded at December 31, 20X8, that goodwill from its purchase of Slice shares had been impaired
and the correct carrying amount was $2,500. Goodwill and goodwill impairment were assigned proportionately to the controlling and noncontrolling shareholders.
No additional impairment occurred in 20X9.
Trial balance data for Pie and Slice on December 31, 20X9, are as follows:
page 231
Required
a.
Give all consolidation entries needed to prepare a three-part consolidation worksheet as of December 31, 20X9.
b.
Prepare a three-part consolidation worksheet for 20X9 in good form.
c.
Prepare a consolidated balance sheet, income statement, and retained earnings statement for 20X9.
P5–35
Comprehensive Problem: Differential Apportionment
LO 5–2
Pillow Corporation acquired 80 percent ownership of Sheet Company on January 1, 20X7, for $173,000. At that date, the fair value of the noncontrolling interest was
$43,250. The trial balances for the two companies on December 31, 20X7, included the following amounts:
page 232
Additional Information
1. On January 1, 20X7, Sheet reported net assets with a book value of $150,000 and a fair value of $191,250. Accumulated depreciation on Buildings and
Equipment was $60,000 on the acquisition date.
2. Sheet’s depreciable assets had an estimated economic life of 11 years on the date of combination. Goodwill of $25,000 was recorded at the acquisition.
3. Pillow used the equity method in accounting for its investment in Sheet.
4. Detailed analysis of receivables and payables showed that Sheet owed Pillow $16,000 on December 31, 20X7.
Required
a.
Give all journal entries recorded by Pillow with regard to its investment in Sheet during 20X7.
b.
Give all consolidation entries needed to prepare a full set of consolidated financial statements for 20X7.
c.
Prepare a three-part consolidation worksheet as of December 31, 20X7.
P5–36
Comprehensive Problem: Differential Apportionment in Subsequent Period
LO 5–2
This problem is a continuation of P5-35. Pillow Corporation acquired 80 percent ownership of Sheet Company on January 1, 20X7, for $173,000. At that date, the fair
value of the noncontrolling interest was $43,250. The trial balances for the two companies on December 31, 20X8, included the following amounts:
Additional Information
1. On January 1, 20X7, Sheet reported net assets with a book value of $150,000 and a fair value of $191,250. The difference between fair value and book value of
Sheet’s net assets is related entirely to buildings and equipment. Accumulated depreciation on buildings and equipment was $60,000 on the acquisition date.
Sheet’s depreciable assets had an estimated economic life of 11 years on the date of combination.
2. At December 31, 20X8, Pillow’s management reviewed the amount attributed to goodwill and concluded goodwill was impaired and should be reduced to
$14,000. Goodwill and goodwill impairment were assigned proportionately to the controlling and noncontrolling shareholders.
3. Pillow used the equity method in accounting for its investment in Sheet.
page 233
4. Detailed analysis of receivables and payables showed that Pillow owed Sheet $9,000 on December 31, 20X8.
Required
a.
Give all journal entries recorded by Pillow with regard to its investment in Sheet during 20X8.
b.
Give all consolidation entries needed to prepare a full set of consolidated financial statements for 20X8.
c.
Prepare a three-part consolidation worksheet as of December 31, 20X8.
P5–37
Subsidiary with Other Comprehensive Income in Year of Acquisition
LO 5–4
Pirate Corporation acquired 60 percent ownership of Ship Company on January 1, 20X8, at underlying book value. At that date, the fair value of the noncontrolling
interest was equal to 40 percent of the book value of Ship Company. Accumulated depreciation on buildings and equipment was $75,000 on the acquisition date.
Trial balance data at December 31, 20X8, for Pirate and Ship are as follows:
Additional Information
Ship purchased stock of Row Company on January 1, 20X8, for $30,000 and classified the investment as available-for-sale securities. The value of Row’s securities
increased to $40,000 at December 31, 20X8.
Required
a.
Give all consolidation entries needed to prepare a three-part consolidation worksheet as of December 31, 20X8.
b.
Prepare a three-part consolidation worksheet for 20X8 in good form.
c.
Prepare a consolidated balance sheet, income statement, and statement of comprehensive income for 20X8.
page 234
P5–38
Subsidiary with
Acquisition
Other
Comprehensive
Income
in
Year
Following
LO 5–4
This problem is a continuation of P5-37. Pirate Corporation acquired 60 percent ownership of Ship Company on January 1, 20X8, at underlying book value. At that
date, the fair value of the noncontrolling interest was equal to 40 percent of the book value of Ship Company. Accumulated depreciation on buildings and
equipment was $75,000 on the acquisition date. Trial balance data at December 31, 20X9, for Pirate and Ship are as follows:
Additional Information
Ship purchased stock of Row Company on January 1, 20X8, for $30,000 and classified the investment as available-for-sale securities. The value of Row’s securities
increased to $40,000 and $44,000, respectively, at December 31, 20X8, and 20X9.
Required
a.
Give all consolidation entries needed to prepare a three-part consolidation worksheet as of December 31, 20X9.
b.
Prepare a three-part consolidation worksheet for 20X9 in good form.
P5–39
Comprehensive Problem: Majority-Owned Subsidiary
LO 5–2
Pizza Corporation acquired 80 percent ownership of Slice Products Company on January 1, 20X1, for $160,000. On that date, the fair value of the noncontrolling
interest was $40,000, and Slice reported retained earnings of $50,000 and had $100,000 of common stock outstanding. Pizza has used the equity method in
accounting for its investment in Slice.
Trial balance data for the two companies on December 31, 20X5, are as follows:
page 235
Additional Information
1. On the date of combination, the fair value of Slice’s depreciable assets was $50,000 more than book value. The accumulated depreciation on these assets was
$10,000 on the acquisition date. The differential assigned to depreciable assets should be written off over the following 10-year period.
2. There was $10,000 of intercorporate receivables and payables at the end of 20X5.
Required
a.
Give all journal entries that Pizza recorded during 20X5 related to its investment in Slice.
b.
Give all consolidation entries needed to prepare consolidated statements for 20X5.
c.
Prepare a three-part worksheet as of December 31, 20X5.
1
https://www.sec.gov/Archives/edgar/data/104169/000010416913000011/annualreporttoshareholders.htm
2
To view a video explanation of this topic, visit advancedstudyguide.com.
3
As noted in Chapter 2, the cost basis for this type of investment would entail classifying these shares
either as trading or available-for-sale securities.
4
Other comprehensive income elements include foreign currency translation adjustments, unrealized gains and
losses on certain derivatives and investments in certain types of securities, and certain minimum pension
liability adjustments.
page 236
6
Intercompany Inventory Transactions
Multicorporate Entities
Business Combinations
Consolidation Concepts and Procedures
Intercompany Transfers
Additional Consolidation Issues
Multinational Entities
Reporting Requirements
Partnerships
Governmental and Not-for-Profit Entities
Corporations in Financial Difficulty
INVENTORY TRANSFERS AT SAMSUNG ELECTRONICS
Most people are familiar with Samsung’s products, from cell phones to tablets to flat screens. Samsung was formed in Korea in 1938 as a trading company.
However, over the years, the company expanded into various industries, including textiles, insurance, food processing, securities, and retail. In the 1960s,
Samsung diversified into electronics, and in the 1970s it expanded into construction and shipbuilding. While Samsung Heavy Industries is the world’s
second-largest shipbuilder, the best known of Samsung’s segments is clearly its electronics business.
Samsung Electronics is the world’s largest manufacturer of LCD panels, televisions, mobile phones, smartphones, and memory chips. It is also a major
vendor for tablet computers, digital cameras, camcorders, batteries, and storage media. In 2013, Samsung Electronics was responsible for 17 percent of
South Korea’s Gross Domestic Product (GDP). The company has assembly plants and sales networks in 80 countries and employs more than 370,000
people. Samsung Electronics has 169 subsidiaries, most of which are wholly owned, such as Samsung Semiconductor, Samsung Electronics Digital Printing,
Dacor appliances, and Samsung Telecommunications Indonesia, as well as other majority-owned subsidiaries such as Samsung Display and STECO. While
each of its many subsidiaries operates as a stand-alone company, technologies and components are often exchanged via intercompany transactions. For
example, Samsung Electronics’ 2016 annual report indicates that approximately 58 percent of its total revenues resulted from intercompany sales
transactions. The reason Samsung Electronics sells so much inventory to affiliated companies is because of its vertical integration strategy. According to
Forbes magazine, “Samsung’s strategy underscores a competitive advantage: the South Korean company is able to bring products to the market more quickly
than [competitors] because it controls the entire manufacturing process for its smartphones. Samsung makes everything from chips to screens at its own
factories, allowing it to change designs and pump out new products at a rapid pace.”1
Transactions between the affiliated companies are not considered arm’s-length. These transactions are sometimes called related-party transactions.
Generally accepted accounting principles only allow companies to recognize sales to third-party buyers outside the consolidated entity. Hence, Samsung
Electronics eliminates all within-group sales in calculating consolidated sales revenues. This elimination is required because all companies owned or controlled
by Samsung Electronics are, in essence, parts of the same company, and a company cannot make a profit by selling inventory to itself. This chapter
examines intercompany inventory transactions and the consolidation procedures associated with them.
page 237
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO 6–1
Understand and explain intercompany transfers and why they must be eliminated.
LO 6–2
Understand and explain concepts associated with inventory transfers and transfer pricing.
LO 6–3
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following downstream inventory
transfers.
LO 6–4
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following upstream inventory
transfers.
LO 6–5
Understand and explain additional considerations associated with consolidation.
OVERVIEW OF THE CONSOLIDATED ENTITY AND INTERCOMPANY TRANSACTIONS
L O 6 –1
Understand and explain intercompany transfers and why they must be eliminated.
The consolidated entity is an aggregation of a number of different companies. The financial statements prepared by the individual affiliates are consolidated
into a single set of financial statements representing the financial position and operating results of the entire economic entity as if it were a single company.
A parent company and its subsidiaries often engage in a variety of transactions among themselves. For example, manufacturing companies often have
subsidiaries that develop raw materials or produce components to be included in the products of affiliated companies. Some companies sell consulting or
other services to affiliated companies. United States Steel Corporation and its subsidiaries engage in numerous transactions with one another, including sales
of raw materials, fabricated products, and transportation services. Such transactions often are critical to the operations of the overall consolidated entity.
These transactions between related companies are referred to as intercompany or intercorporate transfers.
F I G U R E 6 –1
Transactions of Affiliated Companies
Figure 6–1 illustrates a consolidated entity with each of the affiliated companies engaging in both intercompany transfers and transactions with external
parties. From a consolidated viewpoint, only transactions with parties outside the economic entity are included in the income statement. Thus,
page 238
the arrows crossing the perimeter of the consolidated entity in Figure 6–1 represent transactions that are included in the operating results of
the consolidated entity for the period. Transfers between the affiliated companies, shown in Figure 6–1 as those arrows not crossing the boundary of the
consolidated entity, are equivalent to transfers between operating divisions of a single company and are not reported in the consolidated statements.
The central idea of consolidated financial statements is that they report on the activities of the consolidating affiliates as if the separate affiliates actually
constitute a single company. Because single companies are not permitted to reflect internal transactions in their financial statements, consolidated entities also
must exclude the effects of transactions that are totally within the consolidated entity from their financial statements. Building on the basic consolidation
procedures presented in earlier chapters, this chapter and the next two deal with the effects of intercompany transfers. This chapter deals with intercompany
inventory sales, and Chapters 7 and 8 discuss intercompany services, fixed asset sales, and intercompany debt transfers.
Elimination of Intercompany Transfers
Only arm’s-length transactions (i.e., those conducted between completely independent parties who act in their own best interests) may be reflected in the
consolidated financial statements. 2 Thus, all aspects of intercompany transfers must be eliminated in preparing consolidated financial statements so that the
statements appear as if they were those of a single company. ASC 810 mentions open account balances, security holdings, sales and purchases, and interest
and dividends as examples of the intercompany balances and transactions that must be eliminated.
No distinction is made between wholly owned and less-than-wholly-owned subsidiaries with regard to the elimination of intercompany transfers. The
focus in consolidation is on the single-entity concept rather than on the percentage of ownership. Once the conditions for consolidation are met, a company
becomes part of a single economic entity, and all transactions with consolidated companies become internal transfers that must be eliminated fully, regardless
of the level of ownership held.
Elimination of Unrealized Profits and Losses
Companies usually record transactions with affiliates in their accounting records on the same basis as transactions with nonaffiliates, including the
recognition of profits and losses. Profit or loss from selling an item to a related party normally is considered realized at the time of the sale from the selling
company’s perspective, but the profit is not considered realized for consolidation purposes until confirmed, usually through resale to an unrelated party. This
unconfirmed profit from an intercompany transfer is referred to as unrealized intercompany profit.
Unrealized profits and losses are always eliminated in the consolidation process using worksheet consolidation entries. However, companies sometimes
differ on the question of whether the parent company should also remove the effects of intercompany transactions from its books through equity method
journal entries. To maintain consistency with prior chapters, we advocate the fully adjusted equity method, which requires the parent to adjust its books to
remove the effects of intercompany transactions. This method ensures that the parent’s books are fully up-to-date and reflect the results of operations for the
whole consolidated entity. By removing the effects of intercompany transactions, the parent ensures that (1) its income is equal to the
page 239
controlling interest in consolidated income and (2) its retained earnings balance is equal to consolidated retained earnings amount in the
consolidated financial statements. 3
INVENTORY TRANSACTIONS
L O 6 –2
Understand and explain concepts associated with inventory transfers and transfer pricing.
Inventory transactions are the most common form of intercompany exchange. All revenue and expense items recorded by the participants must be eliminated
fully in preparing the consolidated income statement, and the recorded value of transferred assets must be adjusted so that they appear in the consolidated
balance sheet at the original owner’s cost. Moreover, under the fully adjusted equity method, unrealized profits and losses on intercompany transfers are
deferred until the items are sold to a nonaffiliate.
The recordkeeping process for intercompany inventory transfers may be more complex than for other forms of transfers. Companies often have many
different types of inventory items, and some may be transferred from affiliate to affiliate. Also, the problems of keeping tabs on which items have been resold
and which items are still on hand are greater in the case of inventory transactions because part of a shipment may be sold immediately by the purchasing
company and other units may remain on hand for one or more accounting periods. 4
Worksheet Consolidation Entries
The worksheet entries ensure that only the cost of the inventory to the consolidated entity is (1) included in the consolidated balance sheet when the
inventory is still on hand and (2) charged to cost of goods sold in the period the inventory is resold to nonaffiliates.
Transfers at Cost
Merchandise is sometimes sold to related companies at the seller’s cost or carrying value. When an intercorporate sale includes no profit or loss, the balance
sheet inventory amounts at the end of the period require no adjustment for consolidation because the purchasing affiliate’s inventory carrying amount is the
same as the cost to the transferring affiliate and the consolidated entity. At the time the inventory is resold to a nonaffiliate, the amount recognized as cost of
goods sold by the affiliate making the outside sale is the cost to the consolidated entity.
Even when the intercorporate sale includes no profit or loss, however, a worksheet consolidation entry is needed to remove both the revenue and the cost
of goods sold recorded by the seller from the intercorporate sale and any unpaid payable or receivable balance that may remain. This worksheet consolidation
entry avoids overstating these accounts. The consolidation entry does not affect consolidated net income when the transfer is made at cost because both
revenue and cost of goods sold are reduced by the same amount.
Transfers at a Profit or Loss
Companies use many different approaches in setting intercorporate transfer prices. In some companies, the sale price to an affiliate is the same as the price to
any other customer. Some companies routinely mark up inventory transferred to affiliates by a certain percentage of cost. Other companies have page 240
elaborate transfer pricing policies designed to encourage internal sales. Regardless of the method used in setting intercorporate transfer prices, the
consolidation process must remove the effects of such sales from the consolidated statements.
FYI
To minimize tax liabilities, companies often transfer inventory at a profit or loss to shift income to
jurisdictions with lower tax rates. However, strict federal tax laws limit the transfer of profits outside
the United States.
Calculating Unrealized Profit or Loss
The calculation of unrealized intercompany profit or loss is an important step in eliminating the effects of intercompany transfers. In order to illustrate this
calculation, it is important to first understand that there are two types of intercompany inventory transfers: (1) a transfer from one affiliate to another, which
is then sold to an independent nonaffiliate and (2) a transfer from one affiliate to another, which has not yet been sold to an independent nonaffiliate. Figure
6–2 presents examples of each type of transfer.
F I G U R E 6 –2
Two Types of Intercompany Inventory Transfers
In each case, Company A purchases inventory in an arm’s-length transaction from an independent party. Company A then transfers the inventory to
Company B (an affiliate) at a profit. In case 1, Company B eventually sells the inventory to an unrelated party. However, in case 2, Company B still holds the
inventory at the end of the reporting period. The gross profit on the case 2 transfer from Company A to Company B represents unrealized intercompany
profit because the inventory has not yet been sold to an independent party. When companies sell to affiliated companies on a regular basis, at the end of a
reporting period, some of the inventory is often still on hand awaiting sale to an independent party. Thus, the two cases in Figure 6–2 could represent
intercompany sales between the same two companies (1) during the period and (2) just prior to the end of the period. The following chart summarizes these
intercompany inventory transactions:
Total
(1)
(2)
Intercompany
Resold to
Inventory
Sales
Nonaffiliate on Hand
Sales
$4,000
$3,000
$1,000
– COGS
3,200
2,400
800
800
600
200
Gross Profit
GP%
20%
page 241
Company A has total intercompany sales of $4,000 to Company B with total gross profit on these sales of $800. These sales can be divided into two
categories: (1) those that Company B eventually resells during the current period, $3,000, and (2) those that are still in Company B’s inventory at the end of
the accounting period, $1,000. The gross profit on the intercompany sales that have not yet been realized through a sale to an independent third party, $200,
should be deferred until this inventory is eventually resold to a nonaffiliate. Under the fully adjusted equity method, this unrealized gross profit is deferred on
the parent company’s books through an equity method entry (discussed in more detail later). All intercompany sales are eliminated in the consolidated
financial statements through a worksheet consolidation entry(ies).
CAUTION
Note that all numbers in this chart are stated from Company A’s perspective. Columns 2 and 3 simply break
out the portion of the total column that was (1) resold or (2) still on hand in Company B’s ending
inventory. For example, the inventory in case 1 was eventually resold to a nonaffiliate for $3,500.
However, this chart reports only what happened to Company A’s sales.
It is sometimes necessary to use the gross profit percentage to estimate the unrealized gross profit on intercompany transfers, assuming that the selling
company uses a constant markup percentage on all intercompany transfers. For example, assume that Company A transfers inventory costing $9,000 to
Company B, an affiliated company, for $10,000. At the end of the accounting period, Company B still has $3,000 of this inventory on hand in its warehouse.
To calculate the unrealized profit given this limited information, first calculate gross profit and gross profit percentage on total intercompany sales.
Total
(1)
(2)
Intercompany
Resold to
Inventory
Sales
Nonaffiliate on Hand
Sales
– COGS
$10,000
3,000
9,000
Gross Profit
???
Gross profit is $1,000. Thus, the gross profit percentage is 10 percent ($1,000 ÷ $10,000). If we assume the gross profit percentage is the same across all
intercompany sales, we can estimate the unrealized gross profit on intercompany sales (lower right-hand corner of the chart) by multiplying the balance on
hand in intercompany inventory by the gross profit percentage to calculate the unrealized gross profit of $300 ($3,000 × 10%).
Total
(1)
(2)
Intercompany
Resold to
Inventory
Sales
Nonaffiliate on Hand
Sales
$10,000
– COGS
9,000
Gross Profit
1,000
GP%
10%
$3,000
300
CAUTION
Students are sometimes confused when given information about markup on cost. Obviously, markup on cost is
not the same ratio as the markup on transfer price. Nevertheless, students often mix them up. Be careful
to ensure that you use the markup on transfer price (gross profit percentage) to calculate unrealized
gross profit!
Hint:
Markup on cost = Gross Profit / COGS
Markup on transfer price = Gross Profit / Sales = GP%
Inventory transfer problems often use terminology that is unfamiliar. For example, the selling price of the inventory is sometimes called the transfer price
and the gross profit on intercompany sales is often referred to simply as the markup. Based on these definitions, another term for gross profit percentage is
simply markup on sales. Similarly, markup on cost is the ratio of gross profit divided by cost of goods sold. When provided with information about markup
on cost, this information must first be used to calculate cost of goods sold. Then calculate gross profit and gross profit percentage to
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determine unrealized gross profit on intercompany inventory transfers.
As an example, assume that Company A transfers inventory to an affiliate, Company B, for $5,000 with a 25 percent markup on cost and that Company
B resells $3,500 of this inventory to nonaffiliates during the accounting period. How much unrealized gross profit from Company A’s intercompany sales
should be deferred at the end of the period? This information can be summarized as follows:
Total
(1)
(2)
Intercompany
Resold to
Inventory
Sales
Nonaffiliate on Hand
Sales
$5,000
$3,500
– COGS
Gross Profit
???
GP%
When the information is given in terms of markup on cost, we must first calculate the cost of goods sold. Because the markup on cost is given as 25
percent, we can express this relationship by defining cost of goods sold as C and then expressing the markup (gross profit) as 0.25C.
Total
(1)
(2)
Intercompany
Resold to
Inventory
Sales
Nonaffiliate on Hand
Sales
$5,000
– COGS
C
Gross Profit
$3,500
0.25C
???
GP%
Thus, we can solve for cost of goods sold algebraically as follows:
We can then calculate gross profit percentage (markup on transfer price) of 20 percent ($1,000 ÷ $5,000). Moreover, we can solve for Company B’s ending
inventory balance of $1,500 ($5,000 – $3,500 resold).
Total
(1)
(2)
Intercompany
Resold to
Inventory
Sales
Nonaffiliate on Hand
Sales
$5,000
– COGS
4,000
Gross Profit
1,000
GP%
20%
$3,500
$1,500
???
Finally, we can calculate the unrealized gross profit of $300 ($1,500 × 20%).
The chart above provides valuable information for two important accounting tasks. First, the number in the lower right-hand corner represents the
unrealized profit or loss that must be deferred. The parent company makes an equity method journal entry to defer the portion of the unrealized profits that
accrues to the controlling interest. After all the missing numbers in the chart are filled in, it can then be used to prepare consolidation entries to defer
unrealized profit and to adjust the recorded value of inventory to reflect the actual purchase price when it was purchased from a nonaffiliate.
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Deferring Unrealized Profit or Loss on the Parent’s Books
For consolidation purposes, profits recorded on an intercorporate inventory sale are recognized in the period in which the inventory is resold to an unrelated
party. Until the point of resale, all intercorporate profits must be deferred. When a parent company sells inventory to a subsidiary, referred to as a
downstream sale, any profit or loss on the transfer accrues to the parent company’s stockholders. When a subsidiary sells inventory to its parent, an
upstream sale, any profit or loss accrues to the subsidiary’s stockholders. If the subsidiary is wholly owned, all profit or loss ultimately accrues to the parent
company as the sole stockholder. If, however, the selling subsidiary is not wholly owned, the profit or loss on the upstream sale is apportioned between the
parent company and the noncontrolling shareholders.
In addition to deferring unrealized profits and losses on the consolidation worksheet, under the fully adjusted equity method, an unrealized profit or loss
on intercompany inventory transfers is deferred on the parent’s books to ensure that the parent company’s (1) net income equals the controlling interest in
consolidated income and (2) retained earnings equal consolidated retained earnings. The only question is whether all (with downstream transactions) or the
parent’s proportionate share (with upstream transactions) of the unrealized gross profit should be deferred on the parent’s books. 5 The journal entry on the
parent’s books to defer unrealized gross profit follows:
Income from Subsidiary
Investment in Subsidiary
XXX
XXX
The unrealized gross profit is calculated as demonstrated in the previous subsection. In downstream transactions, the parent company uses this journal entry
to defer the entire amount. In upstream transactions, the parent defers only its proportional share of the unrealized gross profit.
CAUTION
On downstream transactions, the parent defers all (i.e., 100% of) unrealized profits and losses, whether
the parent owns 100% or less than 100% of the subsidiary. On upstream transactions, the parent always
defers its ownership percentage of unrealized profits and losses.
Unrealized profits or losses are deferred only until they are realized. In most cases, inventory on hand at the end of one period is sold in the next period.
Once the inventory is sold to an unaffiliated party, the previously deferred amount is recognized in the period of the arm’s-length sale by reversing the
deferral on the parent’s books as follows:
Investment in Subsidiary
XXX
Income from Subsidiary
XXX
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Deferring Unrealized Profit or Loss in the Consolidation
When intercompany sales include unrealized profits or losses, the worksheet entry(ies) needed for consolidation in the period of transfer must adjust
accounts in both the consolidated income statement and balance sheet:
Income statement: Sales and cost of goods sold. All sales revenue from intercompany transfers and the related cost of goods sold recorded by the transferring
affiliate must be removed.
Balance sheet: Inventory. The entire unrealized profit or loss on intercompany transfers must be removed from inventory so that it will be reported at the cost to
the consolidated entity.
The resulting financial statements appear as if the intercompany transfer had not occurred.
To understand how to eliminate the effects of intercompany inventory transfers in the consolidated financial statements, we refer to the examples
illustrated in Figure 6–2 and assume a perpetual inventory system. One way to eliminate intercompany inventory profits or losses is to separately eliminate the
effects of (1) sales from one affiliate to another that have subsequently been sold to a nonaffiliated party(ies) and (2) sales from one affiliate to another that
have not yet been sold to a nonaffiliated person(s) or entity(ies). To explain how to separately eliminate the effects of these types of inventory transfers, we
repeat the summary of the transactions from Figure 6–2 here:
Total
(1)
(2)
Intercompany
Resold to
Inventory
Sales
Nonaffiliate on Hand
Sales
$4,000
$3,000
$1,000
– COGS
3,200
2,400
800
800
600
200
Gross Profit
We first focus on Column (1), which summarizes all sales of inventory from Company A to Company B that have eventually been sold to a nonaffiliated
party. The inventory was originally purchased in an arm’s-length transaction for $2,400. It was then transferred from Company A to Company B for $3,000.
Finally, this inventory was sold to an unrelated party for $3,500. The only portion of this transaction that does not involve an unaffiliated party is the $3,000
internal transfer, which needs to be eliminated. In this transaction, it turns out that Company A’s transfer price (sales revenue) is $3,000. Company B
originally records its inventory at this same amount, but when it is sold, $3,000 is removed from inventory and recorded as cost of goods sold. Thus, the
worksheet consolidation entry to remove the effects of this transfer removes Company A’s sales revenue and Company B’s cost of goods sold related to this
intercompany transfer as follows:
Sales
3,000
Cost of Goods Sold
3,000
We next turn our attention to Column (2), which summarizes all inventory sales from Company A to Company B that are not yet sold to a nonaffiliated
party. Company A originally purchased the inventory from an unaffiliated party for $800 and then transferred it to Company B for $1,000. The unrealized
gross profit on this transfer is $200. Two problems are associated with this transaction. First, Company A’s income is overstated by $200. Second, Company
B’s inventory is overstated by $200. Although the inventory was purchased in an arm’s-length transaction for $800, the intercompany transfer resulted in the
recorded value of the inventory being increased by $200. To ensure that the consolidated financial statements will appear as if the inventory had stayed on
Company A’s books (as if it had not been transferred), we prepare the following worksheet consolidation entry:
page 245
Sales
1,000
Cost of Goods Sold
800
Inventory
200
These two consolidation entries could also be combined. The combined entry would appear as follows:
Sales
4,000
Cost of Goods Sold
3,800
Inventory
200
After preparing the three-by-three internal inventory transfer summary chart, this elimination combined entry can be taken directly from the chart. The debit
to sales is always the number in the upper left-hand corner (total intercompany sales). The credit to cost of goods sold is always the sum of the numbers in
the middle column of the top row (intercompany sales that are eventually resold to nonaffiliates) and the middle row of the third column (intercompany cost
of goods sold on inventory still on hand). Finally, the credit to inventory is the unrealized gross profit number in the lower right column. The purpose of this
credit to inventory is to ensure that inventory appears in the consolidated financial statements at the original cost from an arm’s-length transaction.
The net effect of this combined worksheet consolidation entry is to remove the gross profit on all intercompany sales and to adjust the ending intercompanytransferred inventory back to its original cost. Thus, one consolidation entry can remove the effects of all intercompany inventory transfers during the
accounting period.
We note that the basic consolidation entry is modified slightly when intercompany profits associated with inventory transfers result in unrealized profits.
We illustrate this modification later in several examples.
Assuming the inventory in Column (2), which is still on hand at the end of the first year, is subsequently sold in the following year, recognizing the
deferred gross profit from the first year in the second year would then be appropriate. The worksheet entry to essentially force this now realized gross profit
to be recognized in the consolidated financial statements in year 2 is to credit Cost of Goods Sold and debit the Investment in Subsidiary account as follows:
Investment in Subsidiary
Cost of Goods Sold
200
200
Because the overvalued intercompany inventory in beginning inventory is charged to cost of goods sold at the time of the inventory’s sale to an unrelated
party during the period, the cost of the goods sold is overstated. Thus, a credit to Cost of Goods Sold corrects this account balance and increases income by
the amount of gross profit that was deferred in the prior year. The debit goes to Investment in Subsidiary. Note that we prepared an equity-method
adjustment in the previous year to defer the unrealized gross profit. We can say that this entry artificially decreased the investment account, so we debit that
amount back into the investment account so that the account essentially increases back to its correct balance so that it can be eliminated by the basic
consolidation entry. We demonstrate how this works later in the chapter.
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Why Adjust the Parent’s Books and Make Worksheet Entries?
We defer unrealized intercompany profit or loss to ensure that the parent’s books are completely up-to-date. To be consistent with prior chapters, the fully
adjusted equity method requires a journal entry to defer intercompany profit/loss to ensure that the parent’s net income equals the controlling interest in
consolidated net income and that the parent’s retained earnings is equal to consolidated retained earnings. However, even though we “fix” the parent’s books
through an equity-method journal entry, the Investment in Subsidiary and the Income from Subsidiary accounts are eliminated in the consolidation process.
However, without a worksheet consolidation entry, sales and cost of goods sold would be overstated on the income statement and inventory would be
overstated on the balance sheet. Thus, even though we ensure that the parent’s books are up-to-date, we still need to remove the effects of intercompany
inventory transfers from the consolidated financial statements.
DOWNSTREAM INVENTORY SALE 6
L O 6 –3
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following downstream inventory transfers.
Consolidated net income must be based on realized income. Because intercompany profits from downstream sales are on the parent’s books, consolidated net
income and the overall claim of parent company shareholders must be reduced by the full amount of the unrealized profits.
When a company sells an inventory item to an affiliate, one of three situations results: (1) the item is resold to a nonaffiliate during the same period, (2)
the item is resold to a nonaffiliate during the next period, or (3) the item is held for two or more periods by the purchasing affiliate. 7 We use the continuing
example of Peerless Products Corporation and Special Foods Inc. to illustrate the consolidation process under each of the alternatives. Picking up with the
example in Chapter 3, to illustrate more fully the treatment of unrealized intercompany profits, assume the following with respect to the Peerless and Special
Foods example used previously:
Peerless Products Corporation purchases 80 percent of Special Foods Inc.’s stock on December 31, 20X0, at
the stock’s book value of $240,000. The fair value of Special Foods’ noncontrolling interest on that date is
$60,000, the book value of those shares.
Peerless accounts for its investment in Special Foods using the equity method under which it records its share
of Special Foods’ net income and dividends and also adjusts for unrealized intercompany profits using the fully
adjusted equity method.
Year 1
As an illustration of the effects of a downstream inventory sale, assume the following for Year 1:
1. Peerless reports separate income of $140,000 income from regular operations and declares dividends of $60,000.
2. Special Foods reports net income of $50,000 and declares dividends of $30,000.
3. On November 1, 20X1, Peerless buys inventory for $7,000 and resells it to Special Foods for $10,000 on December 1. As of year-end, these inventory items have not
been resold and they are included in Special Foods inventory as of December 31, 20X1. Special Foods subsequently sells all of this inventory to a nonaffiliated
party for $15,000, but this sale occurs on January 2, 20X2.
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Entries for Inventory Transactions
Peerless records the following entries on its books:
November 1, 20X1
(1)
Inventory
7,000
Cash
7,000
Record inventory purchase.
December 1, 20X1
(2)
Cash
10,000
Sales
10,000
Record sale of inventory to Special Foods.
(3)
Cost of Goods Sold
7,000
Inventory
7,000
Record cost of inventory sold to Special Foods.
Special Foods records the purchase of the inventory from Peerless with the following entry:
December 1, 20X1
(4)
Inventory
10,000
Cash
10,000
Record purchase of inventory from Peerless.
Resale in Period Following Intercorporate Transfer
When inventory is sold to an affiliate at a profit but is not resold during the same period, appropriate adjustments are needed to prepare consolidated financial
statements in the period of the intercompany sale and in each subsequent period until the inventory is sold to a nonaffiliate. The following diagram and chart
represent the intercompany inventory transaction where Peerless Products purchases inventory on November 1, 20X1, for $7,000 and sells the inventory to
Special Foods for $10,000 on December 1, 20X1. Special Foods sells the inventory to a nonaffiliated party for $15,000 on January 2, 20X2, as follows:
This inventory transfer can be summarized as follows:
Total
(1)
Intercompany
Resold to
Sales
Nonaffiliate
(2)
Inventory
on Hand
Sales
$10,000
0
$10,000
– COGS
7,000
0
7,000
3,000
0
3,000
Gross Profit
As of the end of 20X1, the entire intercompany inventory is still on hand in Special Foods’ warehouse. In this case, all the intercompany gross profit is
unrealized at December 31, 20X1. Thus, Peerless needs to defer the entire intercompany gross profit on its books because none of the page 248
intercompany profit has been realized through resale of the inventory to an external party during the current period. In other words, the summary
chart indicates that there is $10,000 of intercompany inventory on hand at the end of the period and the unrealized profit of $3,000 must be deferred on
Peerless’s books as shown in entry (7). During 20X1, Peerless records the purchase of the inventory and the sale to Special Foods with journal entries (1)
through (3), given previously; Special Foods records the purchase of the inventory from Peerless with entry (4).
Equity-Method Entries—20X1
Under the equity method, Peerless records its share of Special Foods’ income and dividends for 20X1:
(5)
Investment in Special Foods
40,000
Income from Special Foods
40,000
Record Peerless’s 80% share of Special Foods’ 20X1 income.
(6)
Cash
Investment in Special Foods
24,000
24,000
Record Peerless’s 80% share of Special Foods’ 20X1 dividend.
As a result of these entries, the ending balance in the investment account is currently $256,000 ($240,000 + $40,000 − $24,000). However, because the
downstream sale of inventory to Special Foods results in $3,000 of unrealized profits, Peerless defers the unrealized gross profit by making an adjustment in
the equity method investment and income accounts to reduce the income from Special Foods on the income statement and Investment in Special Foods on
the balance sheet by its share of the unrealized gross profit. Because this is a downstream transaction, the sale (and associated unrealized gross profit) resides
on Peerless’s income statement. Because we assume the NCI shareholders do not own Peerless stock, they do not share in the deferral of the unrealized
profit. Under the fully adjusted equity method, Peerless defers the entire $3,000 using the following equity-method entry:
(7) Income from Special Foods
Investment in Special Foods
3,000
3,000
Defer unrealized gross profit on inventory sales to Special Foods not yet resold at ​December 31, 20X1.
Note that this entry accomplishes two important objectives. First, because Peerless’s income is overstated by $3,000, the adjustment to Income from Special
Foods offsets this overstatement so that Peerless’s bottom-line net income is now correct. Second, Special Foods’ inventory is currently overstated by
$3,000. Because the Investment in Special Foods account summarizes Peerless’s investment in Special Foods’ balance sheet, this reduction to the investment
account offsets the fact that Special Foods’ inventory (and thus entire balance sheet) is overstated by $3,000. Thus, after making this equity-method
adjustment to defer the unrealized gross profit, Peerless’s financial statements are now correctly stated. Therefore, Peerless’s reported income page 249
will be exactly equal to the controlling interest in net income on the consolidated financial statements.
Consolidation Entries—20X1
The calculations for the Basic Consolidation entry are similar to calculations we made in Chapter 3 with one adjustment. We begin the calculations by
preparing the analysis of the book value portion of the investment account exactly the same way we did in Chapter 3. In the Book Value Calculations panel
below, we show all of Special Foods’ equity accounts on the right side of the panel. On the left side of the calculations panel, we then allocate 80% of these
amounts to Peerless and 20% of these amounts to NCI. This is the same book value calculation we made in Chapter 3.
In cases where the parent has made an equity method entry to defer unrealized profit due to an intercompany transaction with a subsidiary, we need
to make an adjustment to the basic consolidation entry to adjust for this deferred profit. In 20X1, Peerless recorded entry (7) above to defer $3,000 of
gross profit from the intercompany transfer of inventory to Special Foods. Therefore, in the second panel below, we make the adjustment to defer this
$3,000 of gross profit and also adjust the entry for the ending book value of the investment by this same amount. The amounts highlighted in the calculations
below form the basic consolidation entry which is shown. Note that the descriptions for the line item to eliminate income from Special Foods and the line
item to eliminate investment in Special Foods now include the description “with adjustment.”
page 250
The accumulated depreciation entry is the same as in previous chapters. It is always the amount of the subsidiary’s accumulated depreciation on the
acquisition date.
Although Peerless recorded an equity-method entry to defer the unrealized gross profit, both the Income from Special Foods and Investment in Special
Foods accounts are eliminated with the basic consolidation entry. However, Peerless’s Sales and Cost of Goods Sold amounts are still overstated (by $10,000
and $7,000, respectively). Moreover, Special Foods’ ending inventory is still overstated by $3,000. Simply adding up the Peerless and Special Foods columns
of the consolidation worksheet will result in overstated consolidated net income, total assets, and retained earnings. Therefore, we also record a new
consolidation entry to correct the unadjusted totals to the appropriate consolidated amounts. In doing so, consolidated income is reduced by $3,000 ($10,000
− $7,000). In addition, ending inventory reported on Special Foods’ books is stated at the intercompany exchange price rather than the historical cost to the
consolidated entity. Until Special Foods resells it to an external party, the inventory must be reduced by the amount of unrealized intercompany profit each
time consolidated statements are prepared.
Elimination of Intercompany Sales to Special Foods:
Sales
10,000
Cost of Goods Sold
7,000
Inventory
3,000
This consolidation entry removes the effects of the intercompany inventory sale. The journal entries recorded by Peerless Products and Special Foods in
20X1 on their separate books will result in an overstatement of consolidated gross profit for 20X1 and the consolidated inventory balance at year-end unless
the amounts are adjusted in the consolidation worksheet. The amounts resulting from the intercompany inventory transactions from the separate books of
Peerless Products and Special Foods, and the appropriate consolidated amounts, are as follows:
The following T-accounts summarize the effects of all equity-method entries on Peerless’s books as well as the basic consolidation entry:
page 251
Consolidation Worksheet—20X1
We present the consolidation worksheet prepared at the end of 20X1 in Figure 6–3.
F I G U R E 6 –3
December 31, 20X1, Consolidation Worksheet, Period of Intercompany Sale; Downstream Inventory Sale
Consolidated Net Income—20X1
Consolidated net income for 20X1 is shown as $187,000 in the Figure 6–3 worksheet. This amount is computed and allocated as follows:
Peerless’s separate income
Less: Unrealized intercompany profit on downstream inventory sale
Peerless’s separate realized income
Special Foods’ net income
$140,000
(3,000)
$137,000
50,000
Consolidated net income, 20X1
$187,000
Income to noncontrolling interest ($50,000 × 0.20)
(10,000)
Income to controlling interest
$177,000
page 252
Year 2
As a continuation of our illustration of the effects of a downstream inventory sale, assume the following for Year 2:
1. During 20X2, Peerless reports separate income of $160,000 from regular operations and declares dividends of $60,000.
2. Special Foods reports net income of $75,000 and declares dividends of $40,000.
3. On January 2, 20X2, Special Foods sells all of the inventory it had purchased from Peerless in 20X1 to a nonaffiliated party for $15,000.
4. During 20X2, Peerless buys inventory for $32,000 and resells it to Special Foods for $40,000. Also during 20X2, Special Foods sells some of this inventory to a
nonaffiliated party for $19,000; however, Special Foods has $28,000 of this inventory still on hand at December 31, 20X2.
During 20X2, Special Foods receives $15,000 when it sells to an unaffiliated party the inventory that it had purchased for $10,000 from Peerless in 20X1.
Also, Peerless records its pro rata portion of Special Foods’ net income ($75,000) and dividends ($40,000) for 20X2 with the normal equity-method entries:
(8)
Investment in Special Foods
60,000
Income from Special Foods
60,000
Record Peerless’s 80% share of Special Foods’ 20X2 income.
(9)
Cash
32,000
Investment in Special Foods
32,000
Record Peerless’s 80% share of Special Foods’ 20X2 dividend.
Under the fully adjusted equity method, once the inventory is sold to an unaffiliated party, the deferral in the equity-method accounts is no longer necessary
(see entry (9) from 20X1) and is reversed as follows:
(10)
Investment in Special Foods
3,000
Income from Special Foods
3,000
Reverse the 20X1 gross profit deferral on inventory sold to unaffiliated customers.
Following the same logic we used for entry (7), under the fully adjusted equity method, Peerless defers the unrealized gross profit on 20X2 intercompany
inventory sales. The amount of gross profit to be deferred at December 31, 20X2, is $5,600. This amount is recorded in entry (11) below; the computation
of this amount can be seen from the figure and chart below.
(11) Income from Special Foods
5,600
Investment in Special Foods
5,600
Defer unrealized gross profit on inventory sales to Special Foods not yet resold at ​December 31, 20X2.
Inventory sales from Peerless to Special Foods in 20X2:
page 253
This inventory transfer can be summarized as follows:
Total
(1)
Intercompany
Resold
Sales
Nonaffiliates
Sales
− COGS
= G Profit
(2)
Inventory
On Hand
$40,000
12,000
$28,000
32,000
9,600
22,400
8,000
2,400
5,600
GP %
20.0%
Consolidation Entries—20X2
In 20X2, we use the same approach for the Basic Consolidation Entry computations that we used in 20X1. The Book Value Calculations panel shows all of
Special Foods’ equity accounts on the right side of the panel. On the left side of the calculations panel, we then allocate 80 percent of these amounts to
Peerless and 20 percent of these amounts to NCI. In the bottom Adjustments Panel, we first make an adjustment for the $5,600 of gross profit that Peerless
deferred from intercompany sales in 20X1 in entry (10) above. Then, we make an adjustment for the 20X1 gross profit deferral which Peerless reversed in
20X2 in entry (11). In the Adjustments Panel, both of these adjustments are made in computing the line item amounts to eliminate for Income from Special
Foods and Investment in Special Foods. The descriptions for both of these line items are then labeled as “with adjustment.”
page 254
The accumulated depreciation entry is the same as in previous chapters. It is always the amount of the subsidiary’s accumulated depreciation on the
acquisition date.
An additional consolidation entry is needed to recognize the $3,000 of income that was deferred in 20X1. Whereas the inventory had not yet been sold to an
unaffiliated customer in 20X1 and needed to be deferred, that inventory has now been sold in 20X2 and should be recognized in the consolidated financial
statements.
Reversal of the 20X1 Gross Profit Deferral:
Investment in Special Foods
3,000
Cost of Goods Sold
3,000
The consolidation entry to eliminate the 20X2 intercompany sales is made in the combined form illustrated earlier in this chapter. The amounts for the entry
can be read from the summary chart above.
Elimination of 20X2 Intercompany Sales to Special Foods:
Sales
40,000
Cost of Goods Sold
Inventory
34,400
5,600
Special Foods’ unrealized intercompany profit included in beginning inventory was charged to Cost of Goods Sold when Special Foods sold the inventory
during the period. Thus, consolidated cost of goods sold will be overstated for 20X2 if it is based on the unadjusted totals from the books of Peerless and
Special Foods:
Unlike the period in which the intercompany transfer occurs, no adjustment to sales is required in a subsequent period when the inventory is sold to a
nonaffiliate. The amount reported by Special Foods reflects the sale outside the economic entity and is the appropriate amount to be reported for
consolidation. By removing the $3,000 of intercorporate profit from Cost of Goods Sold with this consolidation entry, the original acquisition page 255
price paid by Peerless Products is reported in Cost of Goods Sold, and $8,000 of gross profit is correctly reported in the consolidated income
statement.
Once the sale is made to an external party, the transaction is complete and no adjustments or consolidation entries related to the intercompany transaction
are needed in future periods. The following T-accounts illustrate the effects of all equity-method journal entries on Peerless’s books as well as the worksheet
entries in the consolidation worksheet.
Consolidation Worksheet—20X2
Figure 6–4 illustrates the consolidation worksheet at the end of 20X2 including all of the consolidation entries presented.
Consolidated Net Income—20X2
Consolidated net income for 20X2 is shown as $238,000 in the Figure 6–4 worksheet. This amount is verified and allocated as follows:
Peerless’s separate income
Reversal of Gross Profit deferred in 20X1
Gross profit deferred in 20X2 on downstream inventory sale
Peerless’s separate realized income
Special Foods’ net income
Consolidated net income, 20X2
$160,000
3,000
(5,600)
$157,400
75,000
$232,400
Income to noncontrolling interest ($75,000 × 0.20)
(15,000)
Income to controlling interest
$217,400
Inventory Held for Two or More Periods
Companies may carry the cost of inventory purchased from an affiliate for more than one accounting period. For example, the cost of an item may be in a
LIFO inventory layer and would be included as part of the inventory balance until the layer is liquidated. Prior to liquidation, a consolidation entry is needed in
the consolidation worksheet each time consolidated statements are prepared to restate the inventory to its cost to the consolidated entity. For example, if
Special Foods continues to hold the inventory purchased from Peerless Products, the following consolidation entry is needed in the consolidation worksheet
each time a consolidated balance sheet is prepared for years following the year of intercompany sale, for as long as the inventory is held:
Investment in Special Foods
Inventory
3,000
3,000
page 256
F I G U R E 6 –4
December 31, 20X2, Consolidation Worksheet, Next Period Following Intercompany Sale; Downstream Inventory Sale
This consolidation entry simply corrects the balance in both the Inventory and Investment in Special Foods accounts. Whereas Peerless recorded an
equity-method adjustment to defer the $3,000 of unrealized gross profit in the year of the intercompany inventory transfer by artificially decreasing the
Investment in Special Foods to offset the overstated inventory balance on Special Foods’ books, this entry simply corrects both accounts. No income
statement adjustments are needed in the periods following the intercorporate sale until the inventory is resold to parties external to the consolidated entity.
UPSTREAM INVENTORY SALE
L O 6 –4
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following upstream inventory transfers.
When an upstream inventory sale occurs and the parent resells the inventory to a nonaffiliate during the same period, all the parent’s equity-method entries
and the consolidation entries in the consolidation worksheet are identical to those in the downstream case.
When the inventory is not resold to a nonaffiliate before the end of the period, worksheet entries are different from the downstream case only by the
apportionment of the unrealized intercompany profit to both the controlling and noncontrolling interests. In this case, because the sale appears
page 257
on Special Foods’ income statement and because the NCI shareholders own 20 percent of Special Foods’ outstanding shares, they are entitled
to 20 percent of Special Foods’ net income. Thus, the deferral of unrealized gross profits accrues to both Peerless and the NCI shareholders. In other words,
the intercompany profit in an upstream sale is recognized by the subsidiary and shared between the controlling and noncontrolling stockholders of the
subsidiary. Therefore, the consolidation of the unrealized intercompany profit must reduce the interests of both ownership groups each period until the resale
of the inventory to a nonaffiliated party confirms the profit.
We illustrate an upstream sale using the same example as used for the downstream sale except that Special Foods sells the inventory to Peerless. Assume
Special Foods purchases the inventory on March 1, 20X1, for $7,000 and sells it to Peerless for $10,000 during the same year. Peerless holds the inventory
until January 2, 20X2, at which time Peerless sells it to a nonaffiliated party for $15,000.
Equity-Method Entries—20X1
Peerless Products records the following equity-method entries in 20X1:
(12)
Investment in Special Foods
40,000
Income from Special Foods
40,000
Record Peerless’s 80% share of Special Foods’ 20X1 income.
(13)
Cash
24,000
Investment in Special Foods
24,000
Record Peerless’s 80% share of Special Foods’ 20X1 dividend.
These entries are the same as in the illustration of the downstream sale. The only difference is that the fully adjusted equity-method entry to defer the
unrealized gross profit is only for Peerless’s ownership percentage of Special Foods (80 percent). Thus, the deferral of Peerless’s relative share page 258
of the unrealized gross profit is $2,400 ($3,000 × 80%).
(14)
Income from Special Foods
Investment in Special Foods
2,400
2,400
Eliminate unrealized gross profit on inventory purchases from Special Foods.
Consolidation Worksheet—20X1
We present the worksheet for the preparation of the 20X1 consolidated financial statements in Figure 6–5. The first two consolidation entries are the same as
we calculated in Chapter 3 with one minor exception. Although the analysis of the book value portion of the investment account is the same, in preparing the
basic consolidation entry, we reduce the amounts in Peerless’s Income from Special Foods and Investment in Special Foods accounts by Peerless’s share of
the deferral, $2,400 ($3,000 × 80%). We also reduce the NCI in net income of Special Foods and NCI in net assets of Special Foods by the NCI share of the
deferral, $600 ($3,000 × 20%).
F I G U R E 6 –5
December 31, 20X1, Consolidation Worksheet, Period of Intercompany Sale; Upstream Inventory Sale
page 259
The consolidation worksheet entry to remove the effects of the intercompany sale is identical to the downstream case. The only difference is that the
overstated Sales and Cost of Goods Sold numbers are now in the Special Foods’ column of the consolidation worksheet and the overstated inventory is now
in the Peerless column.
Eliminate Inventory Purchases from Special Foods (still on hand):
Sales
10,000
Cost of Goods Sold
7,000
Inventory
3,000
page 260
Consolidated Net Income—20X1
We note that because the unrealized profit consolidation is allocated proportionately between the controlling and noncontrolling interests in the upstream case,
the income assigned to the noncontrolling shareholders is $600 ($3,000 × 0.20) less in Figure 6–5 for the upstream case than in Figure 6–3 for the
downstream case. Accordingly, the amount of income assigned to the controlling interest is $600 higher. Note that consolidated net income and all other
income statement amounts are the same whether the sale is upstream or downstream. The worksheet indicates that consolidated net income for 20X1 is
$187,000. Consolidated net income is computed and allocated to the controlling and noncontrolling stockholders as follows:
Peerless’s separate income
$140,000
Special Foods’ net income
$50,000
Less: Unrealized intercompany profit on upstream inventory sale
(3,000)
Special Foods’ realized net income
Consolidated net income, 20X1
Income to noncontrolling interest ($47,000 × 0.20)
Income to controlling interest
47,000
$187,000
(9,400)
$177,600
Equity-Method Entries—20X2
Peerless recognizes its share of Special Foods’ income ($75,000) and dividends ($40,000) for 20X2 with the normal equity-method entries:
(15)
Investment in Special Foods
60,000
Income from Special Foods
60,000
Record Peerless’s 80% share of Special Foods’ 20X2 income.
(16)
Cash
32,000
Investment in Special Foods
32,000
Record Peerless’s 80% share of Special Foods’ 20X2 dividend.
Under the fully adjusted equity method, Peerless reverses the deferred gross profit from 20X1 because this inventory has now been sold.
(17)
Investment in Special Foods
2,400
Income from Special Foods
2,400
Reverse the 20X1 gross profit deferral on inventory sold to unaffiliated customers.
Consolidation Worksheet—20X2
Figure 6–6 illustrates the consolidation worksheet used to prepare consolidated financial statements at the end of 20X2. The first two consolidation entries
are the same as we prepared in Chapter 3 with the previously explained exception. Although the analysis of the book value portion of the investment account
is the same, in preparing the basic consolidation entry and because the inventory sold to Peerless by Special Foods last year has now been sold to an
unaffiliated party, we must now increase the amounts in Peerless’s Income from Special Foods and Investment in Special Foods accounts by Peerless’s
share of the deferral, $2,400 ($3,000 × 80%). We also increase the NCI in net income of Special Foods and NCI in net assets of Special Foods by the NCI
share of the deferral, $600 ($3,000 × 20%).
page 261
F I G U R E 6 –6
December 31, 20X2, Consolidation Worksheet, Next Period following Intercompany Sale; Upstream Inventory Sale
page 262
Similar to the downstream example, the unrealized intercompany profit included in Peerless’s beginning inventory was charged to Cost of Goods Sold
when Peerless sold the inventory during 20X2. Thus, consolidated cost of goods sold will be overstated for 20X2 if it is reported in the consolidated income
statement at the unadjusted total from the books of Peerless and Special Foods. The following consolidation entry corrects Cost of Goods Sold and splits this
adjustment proportionately between Peerless’s investment account and the NCI in net assets of Special Foods.
FYI
Recall that Peerless deferred 80 percent of the unrealized gross profit on the upstream inventory sale
last year on its books through an equity-method journal entry. Thus, the beginning balance in the
Investment account ($253,600) is not equal to Peerless’s 80 percent share of Special Foods’ equity
accounts in the beginning balance line of the Book Value Calculations box above ($256,000). This is why
the basic consolidation entry to the Investment in Special Foods account is increased by the amount of
last year’s deferral.
Reversal of 20X1 Gross Profit Deferral:
Investment in Special Foods
NCI in NA of Special Foods
Cost of Goods Sold
2,400
600
3,000
The following T-accounts illustrate the effects of all equity-method journal entries on Peerless’s books as well as the worksheet consolidation entries.
page 263
Consolidated Net Income—20X2
Consolidated net income for 20X2 is shown as $238,000 in the Figure 6–6 worksheet. This amount is computed and allocated as follows:
Peerless’s separate income
$160,000
Special Foods’ net income
$75,000
Realization of deferred intercompany profit on upstream inventory sale
Special Foods’ realized net income
3,000
78,000
Consolidated net income, 20X2
$238,000
Income to noncontrolling interest ($78,000 × 0.20)
(15,600)
Income to controlling interest
$222,400
ADDITIONAL CONSIDERATIONS
L O 6 –5
Understand and explain additional considerations associated with consolidation.
The frequency of intercompany inventory transfers and the varied circumstances under which they may occur raise a number of additional implementation
issues. We discuss several of these briefly in this section.
Sale from One Subsidiary to Another
Inventory transfers often occur between companies that are under common control or ownership. When one subsidiary sells merchandise to another
subsidiary, the consolidation entries are identical to those presented earlier for sales from a subsidiary to its parent. The full amount of any unrealized
intercompany profit is eliminated, with the profit elimination allocated proportionately against the selling subsidiary’s ownership interests.
As an illustration, assume that Peerless Products owns 90 percent of the outstanding stock of Super Industries in addition to its 80 percent interest in
Special Foods. If Special Foods sells inventory at a $3,000 profit to Super Industries for $10,000 and Super Industries holds all of the inventory at the end of
the period, the following consolidation entry is among those needed in the consolidation worksheet prepared at the end of the period:
Eliminate Intercompany Inventory Sales (still on hand):
Sales
10,000
Cost of Goods Sold
7,000
Inventory
3,000
The two shareholder groups of the selling affiliate allocate proportionately the $3,000 deferral of unrealized intercompany profit. Consolidated net income
is reduced by the full $3,000 unrealized intercompany profit. The income allocated to the controlling interest is reduced by Peerless’s 80 percent share of the
intercompany profit, or $2,400, and Special Foods’ noncontrolling interest is reduced by its 20 percent share, or $600.
Sales and Purchases before Affiliation
Sometimes companies that have sold inventory to one another later join together in a business combination. The consolidation treatment of profits on
inventory transfers that occurred before the business combination depends on whether the companies were at that time independent and the sale page 264
transaction was the result of arm’s-length bargaining. As a general rule, the effects of transactions that are not the result of arm’s-length
bargaining must be eliminated. However, the combining of two companies does not necessarily mean that their prior transactions with one another were not
conducted at arm’s length. The circumstances surrounding the prior transactions, such as the price and quantity of units transferred, would have to be
examined.
In the absence of evidence to the contrary, companies that have joined together in a business combination are viewed as having been separate and
independent prior to the combination. Thus, if the prior sales were the result of arm’s-length bargaining, they are viewed as transactions between unrelated
parties. Accordingly, no consolidation entry or adjustment is needed in preparing consolidated statements subsequent to the combination, even if an affiliate
still holds the inventory.
SUMMARY OF KEY CONCEPTS
Consolidated financial statements are prepared for the consolidated entity as if it were a single company. Therefore, the effects of all transactions between
companies within the entity must be eliminated in preparing consolidated financial statements.
Each time consolidated statements are prepared, all effects of intercompany transactions occurring during that period and the effects of unrealized profits from
transactions in prior periods must be eliminated. For intercompany inventory transactions, the intercompany sale and cost of goods sold must be eliminated. In
addition, the intercompany profit may not be recognized in consolidation until it is confirmed by resale of the inventory to an external party. Unrealized
intercompany profits must be eliminated fully and are allocated proportionately against the stockholder groups of the selling affiliate. If inventory containing
unrealized intercompany profits is sold during the period, consolidated cost of goods sold must be adjusted to reflect the actual cost to the consolidated entity of
the inventory sold; if the inventory is still held at the end of the period, it must be adjusted to its actual cost to the consolidated entity.
KEY TERMS
downstream sale, 243
intercompany transfers, 237
intercorporate transfers, 237
markup, 241
markup on cost, 241
markup on sales, 241
modified equity method, 239
transfer price, 241
unrealized intercompany profit, 238
upstream sale, 243
Appendix 6A
Intercompany Inventory Transactions—
Modified Equity Method and Cost Method
This appendix illustrates consolidation procedures under the modified (or sometimes called the basic) equity method and then the cost method. We use the
upstream sale example presented earlier to illustrate these alternative methods. Assume that Special Foods purchases inventory for $7,000 in 20X1 and, in the same
year, sells the inventory to Peerless Products for $10,000. Peerless Products sells the inventory to external parties in 20X2. Both companies use perpetual inventory
control systems.
MODIFIED EQUITY METHOD
The journal entries on Peerless’s books and the consolidation entries in the consolidation worksheet are the same under the modified equity method as under the
fully adjusted method except for differences related to unrealized intercompany profits. When using the fully adjusted equity method, the parent reduces page 265
its income and the balance of the investment account for its share of unrealized intercompany profits that arise during the period. Subsequently, the
parent increases its income and the carrying amount of the investment account when the intercompany profits are realized through transactions with external
parties. These adjustments related to unrealized gross profit on intercompany sales are omitted under the modified equity method. As a result, the worksheet entry
in the second year to recognize the deferred gross profit from the first year is slightly different. Instead of recording a debit to the investment account, this debit
goes to beginning retained earnings.
Modified Equity-Method Entries—20X1
In 20X1, Peerless Products records the normal equity-method entries reflecting its share of Special Foods’ income and dividends but omits the additional entry to
reduce income and the investment account by the parent’s share of the unrealized intercompany profit arising during the year:
(18)
Investment in Special Foods
Income from Special Foods
Record Peerless’s 80% share of Special Foods’ 20X1 income.
40,000
40,000
(19)
Cash
Investment in Special Foods
24,000
24,000
Record Peerless’s 80% share of Special Foods’ 20X1 dividend.
Consolidation Entries—20X1
Figure 6–7 illustrates the consolidation worksheet for 20X1 under the modified equity method. The consolidation entries are the same as we presented for the fully
adjusted equity method with one minor exception. We do not reduce the amounts in Peerless’s Income from Special Foods and Investment in Special Foods
accounts by Peerless’s share of the deferral, because no adjustment was made to the investment account or income from subsidiary account under the modified
equity method, $2,400 ($3,000 × 80%), but we do reduce the NCI in net income of Special Foods and NCI in net assets of Special Foods by the NCI share of the
deferral, $600 ($3,000 × 20%). Thus, the only adjustments to the book value calculations for the basic consolidation entry are made to the NCI amounts for the
deferral of unrealized gross profit.
page 266
F I G U R E 6 –7
December 31, 20X1, Modified Equity-Method Consolidation Worksheet, Period of Intercompany Sale; Upstream Inventory Sale
Eliminate Inventory Purchases from Special Foods (still on hand):
Sales
10,000
Cost of Goods Sold
7,000
Inventory
3,000
page 267
Modified Equity-Method Entries—20X2
The equity-method journal entries on Peerless’ books are the same as illustrated previously, except that the adjustment for Peerless’ share of the deferral is omitted:
(20)
Investment in Special Foods
60,000
Income from Special Foods
60,000
Record Peerless’s 80% share of Special Foods’ 20X2 income.
(21)
Cash
Investment in Special Foods
32,000
32,000
Record Peerless’s 80% share of Special Foods’ 20X2 dividend.
Consolidation Entries—20X2
Figure 6–8 illustrates the consolidation worksheet for 20X2 under the modified equity method. The first two consolidation entries are the same with one exception.
Because the inventory sold to Peerless by Special Foods last year has now been sold to an unaffiliated party, we now increase the NCI in net income of Special
Foods and NCI in net assets of Special Foods by the NCI share of the deferral, $600 ($3,000 × 20%). However, we do not increase the amounts in Peerless’s Income
from Special Foods and Investment in Special Foods accounts by Peerless’s share of the deferral, $2,400 ($3,000 × 80%), because no adjustment was made to the
investment account or income account under the modified equity method. Again, the only adjustments to the book value calculations for the basic consolidation
entry are made to the NCI amounts for the reversal of last year’s unrealized gross profit.
page 268
F I G U R E 6 –8
December 31, 20X2, Modified Equity-Method Consolidation Worksheet, Next Period Following Intercompany Sale; Upstream Inventory
Sale
Similar to 20X1, the unrealized intercompany profit included in Peerless’ beginning inventory was charged to Cost of Goods Sold when Peerless sold the
inventory during 20X2. Thus, consolidated cost of goods sold will be overstated for 20X2 if it is reported in the consolidated income statement at the unadjusted
total from the books of Peerless and Special Foods. The following consolidation entry corrects Cost of Goods Sold and splits this adjustment proportionately
between beginning Retained Earnings and the NCI in Net Assets of Special Foods.
page 269
Reversal of 20X1 Gross Profit Deferral:
Retained Earnings
NCI in NA of Special Foods
Cost of Goods Sold
2,400
600
3,000
COST METHOD
When using the cost method, the parent records dividends received from the subsidiary as income but makes no adjustments with respect to undistributed income
of the subsidiary or unrealized intercompany profits. As an example of consolidation following an upstream intercompany sale of inventory when the parent
accounts for its investment in the subsidiary using the cost method, assume the same facts as in previous illustrations dealing with an upstream sale.
Consolidation Entries—20X1
Figure 6–9 illustrates the consolidation worksheet for 20X1 under the cost method. The following consolidation entries are needed in the worksheet used to prepare
consolidated financial statements for 20X1 using the cost method:
The amount of undistributed net income assigned to the NCI is adjusted for the NCI’s share of the gross profit deferral.
NCI in NI and NCI in NA of Special Foods:
NCI 20%
Net Income
10,000
− Dividend
(6,000)
− Gross profit deferral
NCI in NI of Special Foods
(600)
3,400
page 270
Eliminate Inventory Purchases from Special Foods (still on hand):
Sales
10,000
Cost of Goods Sold
7,000
Inventory
3,000
F I G U R E 6 –9
December 31, 20X1, Cost Method Consolidation Worksheet, Period of Intercompany Sale; Upstream Inventory Sale
The investment consolidation entry eliminates the original balances in Special Foods’ equity section accounts as of the acquisition date. It simultaneously
eliminates the Investment in Special Foods account and establishes the NCI in Net Assets account (for the NCI share of the Special Foods’ net assets as of the
acquisition date). The dividend consolidation entry eliminates Special Foods’ declared dividends and Peerless’s dividend income and establishes the NCI in net
income with the NCI share of dividends declared. Although Peerless uses the cost method to account for its investment, the consolidated financial page 271
statements still must report the NCI shareholders’ share of Special Foods’ reported net income, and a portion of that income is allocated in the form of a
dividend. Nevertheless, the NCI in net income should report the NCI share of reported income (adjusted for the deferred gross profit on upstream intercompany
sales). Thus, the third consolidation entry assigns the NCI shareholders’ 20 percent of the undistributed income (adjusted for 20 percent of the deferred gross
profit) to both the NCI in Net Income of Special Foods and NCI in Net Assets of Special Foods. The optional accumulated depreciation and deferred gross profit
consolidation entries are the same as those explained for the fully adjusted equity method.
Consolidation Entries–20X2
Figure 6–10 illustrates the consolidation worksheet for 20X2 under the cost method. Consolidation entries needed in the consolidation worksheet prepared at the
end of 20X2 are as follows:
NCI in NI and NCI in NA of Special Foods:
NCI 20%
Net Income
15,000
− Dividend
(8,000)
+ Reverse GP Deferral
600
NCI in NI of Special Foods
7,600
Undistributed from Prior Year
4,000
NCI in NA of Special Foods
11,600
page 272
F I G U R E 6 –1 0
December 31, 20X2, Cost Method Consolidation Worksheet, Next Period Following Intercompany Sale; Upstream Inventory Sale
The investment and dividend consolidation entries are the same as in 20X1. The third entry assigns cumulative undistributed net income from Special Foods. It
assigns 20 percent of the 20X2 net income to the NCI shareholders and 20 percent of the 20X1 net income to retained earnings for the prior year. The accumulated
depreciation consolidation entry is the same as in 20X1. However, the last entry is identical to the entry under the modified equity method.
Similar to 20X1, the unrealized intercompany profit included in Peerless’s beginning inventory was charged to Cost of Goods Sold when Peerless sold the
inventory during 20X2. Thus, consolidated cost of goods sold will be overstated for 20X2 if it is reported in the consolidated income statement at the unadjusted
total from the books of Peerless and Special Foods. The following consolidation entry corrects Cost of Goods Sold and splits this adjustment proportionately
between beginning Retained Earnings and the NCI in Net Assets of Special Foods.
page 273
Reversal of 20X1 Gross Profit Deferral:
Retained Earnings *
NCI in NA of Special Foods
Cost of Goods Sold
2,400
600
3,000
* Note that these entries adjust for the subsidiary’s retained earnings balance. The subsidiary does not adjust for the
deferral of unrealized gross profit because this adjustment is made in the consolidation worksheet, not in the records of
the subsidiary.
QUESTIONS
Q6–1
Why must inventory transfers to related companies be eliminated in preparing consolidated
financial statements?
LO 6–1
Q6–2
Why is there a need for a consolidation entry when an intercompany inventory transfer is made
at cost?
LO 6–2
Q6–3
Distinguish between an upstream sale of inventory and a downstream sale. Why is it important to
know whether a sale is upstream or downstream?
LO 6–3
Q6–4
How do unrealized intercompany profits on a downstream sale of inventory made during the
current period affect the computation of consolidated net income and income to the controlling
interest?
LO 6–3
Q6–5
How do unrealized intercompany profits on an upstream sale of inventory made during the
current period affect the computation of consolidated net income and income to the controlling
interest?
LO 6–4
Q6–6
Will the consolidation of unrealized intercompany profits on an upstream sale or on a
downstream sale in the current period have a greater effect on income assigned to the
noncontrolling interest? Why?
LO 6–3, 6–4
Q6–7
What consolidation entry is needed when inventory is sold to an affiliate at a profit and is resold
to an unaffiliated party before the end of the reporting period? (Assume both affiliates use
perpetual inventory systems.)
LO 6–3
Q6–8
What consolidation entry is needed when inventory is sold to an affiliate at a profit and is not
resold before the end of the period? (Assume both affiliates use perpetual inventory systems.)
LO 6–3
Q6–9
How is the amount to be reported as cost of goods sold by the consolidated entity determined
when there have been intercorporate sales during the period?
LO 6–3, 6–4
Q6–10
How is the amount to be reported as consolidated retained earnings determined when there have
been intercorporate sales during the period?
LO 6–3, 6–4
Q6–11
How is the amount of consolidated retained earnings assigned to the noncontrolling interest
affected by unrealized inventory profits at the end of the year?
LO 6–3, 6–4
Q6–12
How do unrealized intercompany inventory profits from a prior period affect the computation of
consolidated net income when the inventory is resold in the current period? Is it important to
know whether the sale was upstream or downstream? Why, or why not?
LO 6–3, 6–4
Q6–13
How will the elimination of unrealized intercompany inventory profits recorded on the parent’s
books affect consolidated retained earnings?
LO 6–3, 6–4
Q6–14
How will the elimination of unrealized intercompany inventory profits recorded on the
subsidiary’s books affect consolidated retained earnings?
LO 6–3, 6–4
Q6–15 *
Is an inventory sale from one subsidiary to another treated in the same manner as an upstream
sale or a downstream sale? Why?
LO 6–5
Q6–16 *
Par Company regularly purchases inventory from Eagle Company. Recently, Par Company
purchased a majority of the voting shares of Eagle Company. How should Par Company treat
inventory profits recorded by Eagle Company before the day of acquisition? Following the day
of acquisition?
LO 6–5
*
Indicates that the item relates to “Additional Considerations.”
page 274
CASES
C6–1
Measuring Cost of Goods Sold
LO 6–2
Judgment
Shortcut Charlie usually manages to develop some simple rule to handle even the most complex situations. In providing for the elimination of the effects of
inventory transfers between the parent company and a subsidiary or between subsidiaries, Shortcut started with the following rules:
1. When the buyer continues to hold the inventory at the end of the period, credit Cost of Goods Sold for the amount recorded as cost of goods sold by the
company that made the intercompany sale.
2. When the buyer resells the inventory before the end of the period, credit Cost of Goods Sold for the amount recorded as cost of goods sold by the company
that made the intercompany sale plus the profit recorded by that company.
3. Debit Sales for the total amount credited in rule 1 or 2 above.
One of the new employees is seeking some assistance in understanding how the rules work and why.
Required
a.
Explain why rule 1 is needed when consolidated statements are prepared.
b.
Explain what is missing from rule 1, and prepare an alternative or additional statement for the elimination of unrealized profit when the purchasing affiliate does not
resell to an unaffiliated company in the period in which it purchases inventory from an affiliate.
c.
Does rule 2 lead to the correct result? Explain your answer.
d.
The rules do not provide assistance in determining how much profit either of the two companies recorded. Where should the employee look to determine the
amount of profit referred to in rule 2?
C6–2
Inventory Values and Intercompany Transfers
LO 6–1, 6–2
Research
Water Products Corporation has been supplying high-quality bathroom fixtures to its customers for several decades and uses a LIFO inventory system. Rapid
increases in the cost of fixtures have resulted in inventory values substantially below current replacement cost. To bring its inventory carrying costs up to more
reasonable levels, Water Products sold its entire inventory to Plumbers Products Corporation and purchased an entirely new supply of inventory items from
Growinkle Manufacturing. Water Products owns common stock of both Growinkle and Plumbers Products.
Water Products’ external auditor immediately pointed out that under some ownership levels of these two companies, Water Products could accomplish its goal
and under other levels it could not.
Required
Prepare a memo to Water Products’ president describing the effects of intercompany transfers on the valuation of inventories and discuss the effects that different
ownership levels of Growinkle and Plumbers Products would have on the success of Water Products’ plan. Include citations to or quotations from the authoritative
accounting literature to support your position.
C6–3
Unrealized Inventory Profits
LO 6–1
Understanding
Morrison Company owns 80 percent of Bloom Corporation’s stock, acquired when Bloom’s fair value as a whole was equal to its book value. The companies
frequently engage in intercompany inventory transactions.
Required
Name the conditions that would make it possible for each of the following statements to be true. Treat each statement independently.
a.
Income assigned to the noncontrolling interest in the consolidated income statement for 20X3 is higher than a pro rata share of Bloom’s reported net income.
b.
Income assigned to the noncontrolling interest in the consolidated income statement for 20X3 is higher than a pro rata share of Bloom’s reported net income, but
consolidated net income is reduced as a result of the elimination of intercompany inventory transfers.
c.
Cost of goods sold reported in the income statement of Morrison is higher than consolidated cost of goods sold for 20X3.
d.
Consolidated inventory is higher than the amounts reported by the separate companies.
page 275
C6–4
Eliminating Inventory Transfers
LO 6–3, 6–4
Analysis
Ready Building Products has six subsidiaries that sell building materials and supplies to the public and to the parent and other subsidiaries. Because of the
invoicing system Ready uses, it is not possible to keep track of which items have been purchased from related companies and which have been bought from outside
sources. Due to the nature of the products purchased, there are substantially different profit margins on different product groupings.
Required
a.
If no effort is made to eliminate intercompany sales for the period or unrealized profits at year-end, what elements of the financial statements are likely to be
misstated?
b.
What type of control system would you recommend to Ready’s controller to provide the information needed to make the required consolidation entries?
c.
Would it matter if the buyer and seller used different inventory costing methods (FIFO, LIFO, or weighted average)? Explain.
d.
Assume you believe that the adjustments for unrealized profit would be material. How would you go about determining what amounts must be eliminated at the
end of the current period?
C6–5
Intercompany Profits and Transfers of Inventory
LO 6–1, 6–2
Analysis
Many companies transfer inventories from one affiliate to another. Often the companies have integrated operations in which one affiliate provides the raw materials,
another manufactures finished products, another distributes the products, and perhaps another sells the products at retail. In other cases, various affiliates may be
established for selling the company’s products in different geographic locations, especially in different countries. Often tax considerations also have an effect on
intercompany transfers.
Required
a.
Are Xerox Corporation’s intercompany transfers significant? How does Xerox treat intercompany transfers for consolidation purposes?
b.
How does ExxonMobil Corporation price its products for intercompany transfers? Are these transfers significant? How does ExxonMobil treat intercompany
profits for consolidation purposes?
c.
What types of intercompany and intersegment sales does Ford Motor Company have? Are they significant? How are they treated for consolidation?
EXERCISES
E6–1
Multiple-Choice Questions on Intercompany Inventory Transfers [AICPA
Adapted]
LO 6–3, 6–4
Select the correct answer for each of the following questions:
1. Perez Inc. owns 80 percent of Senior Inc. During 20X2, Perez sold goods with a 40 percent gross profit to Senior. Senior sold all of these goods in 20X2. For
20X2 consolidated financial statements, how should the summation of Perez and Senior income statement items be adjusted?
a. Sales and Cost of Goods Sold should be reduced by the intercompany sales amount.
b. Sales and Cost of Goods Sold should be reduced by 80 percent of the intercompany sales amount.
c. Net income should be reduced by 80 percent of the gross profit on intercompany sales amount.
d. No adjustment is necessary.
2. Parker Corporation owns 80 percent of Smith Inc.’s common stock. During 20X1, Parker sold inventory to Smith for $250,000 on the same terms as sales made to
third parties. Smith sold all of the inventory purchased from Parker in 20X1. The following information pertains to Smith’s and Parker’s sales for 20X1:
Parker
Sales
$1,000,000
Cost of Sales
Gross Profit
Smith
$
(400,000)
$
600,000
700,000
(350,000)
$
350,000
What amount should Parker report as cost of sales in its 20X1 consolidated income statement?
page 276
a. $750,000
b. $680,000
c. $500,000
d. $430,000
Note: Items 3 and 4 are based on the following information:
Nolan owns 100 percent of the capital stock of both Twill Corporation and Webb Corporation. Twill purchases merchandise inventory from Webb at 140 percent
of Webb’s cost. During 20X0, Webb sold merchandise that had cost it $40,000 to Twill. Twill sold all of this merchandise to unrelated customers for $81,200
during 20X0. In preparing combined financial statements for 20X0, Nolan’s bookkeeper disregarded the common ownership of Twill and Webb.
3. What amount should be eliminated from cost of goods sold in the combined income statement for 20X0?
a. $56,000
b. $40,000
c. $24,000
d. $16,000
4. By what amount was unadjusted revenue overstated in the combined income statement for 20X0?
a. $16,000
b. $40,000
c. $56,000
d. $81,200
5. Clark Company had the following transactions with affiliated parties during 20X2:
Sales of $60,000 to Dean Inc., with $20,000 gross profit. Dean had $15,000 of this inventory on hand at year-end. Clark owns a 15 percent interest in Dean
and does not exert significant influence.
Purchases of raw materials totaling $240,000 from Kent Corporation, a wholly owned subsidiary. Kent’s gross profit on the sales was $48,000. Clark had
$60,000 of this inventory remaining on December 31, 20X2.
Before consolidation entries, Clark had consolidated current assets of $320,000. What amount should Clark report in its December 31, 20X2, consolidated
balance sheet for current assets?
a. $320,000
b. $317,000
c. $308,000
d. $303,000
6. Selected data for two subsidiaries of Dunn Corporation taken from the December 31, 20X8, preclosing trial balances are as follows:
Banks Co. Lamm Co.
(Debits) (Credits)
Shipments to Banks
$150,000
Shipments from Lamm
$200,000
Intercompany Inventory Profit on Total Shipments
50,000
Additional data relating to the December 31, 20X8, inventory are as follows:
Inventory acquired by Banks from outside parties $175,000
Inventory acquired by Lamm from outside parties
Inventory acquired by Banks from Lamm
250,000
60,000
At December 31, 20X8, the inventory reported on the combined balance sheet of the two subsidiaries should be
page 277
a. $425,000.
b. $435,000.
c. $470,000.
d. $485,000.
E6–2
Multiple-Choice Questions on the Effects of Inventory Transfers [AICPA
Adapted]
LO 6–3
Select the correct answer for each of the following questions.
1. During 20X3, Park Corporation recorded sales of inventory for $500,000 to Small Company, its wholly owned subsidiary, on the same terms as sales made to
third parties. At December 31, 20X3, Small held one-fifth of these goods in its inventory. The following information pertains to Park’s and Small’s sales for 20X3:
Sales
Park
Small
$2,000,000
$1,400,000
Cost of Sales
Gross Profit
(800,000)
$1,200,000
(700,000)
$
700,000
In its 20X3 consolidated income statement, what amount should Park report as cost of sales?
a. $1,000,000
b. $1,060,000
c. $1,260,000
d. $1,500,000
Note: Items 2 through 6 are based on the following information:
Selected information from the separate and consolidated balance sheets and income statements of Power Inc. and its subsidiary, Spin Company, as of December
31, 20X8, and for the year then ended is as follows:
Power
Spin
Consolidated
Balance Sheet Accounts
Accounts Receivable
$ 26,000
$ 19,000
$ 39,000
Inventory
30,000
25,000
52,000
Investment in Spin Company
53,000
Patents
20,000
NCI in NA of Spin Company
Stockholders’ Equity
14,000
154,000
50,000
154,000
$200,000
$140,000
$308,000
150,000
110,000
231,000
$ 50,000
$ 30,000
$ 77,000
$ 15,000
$ 40,000
Income Statement Accounts
Revenues
Cost of Goods Sold
Gross Profit
Income from Spin Company
7,400
Amortization of Patents
Net Income
2,000
$ 33,000
Additional Information
During 20X8, Power sold goods to Spin at the same markup that Power uses for all sales. At December 31, 20X8, Spin had not paid for all of these goods and still
held 37.5 percent of them in inventory.
Power acquired its interest in Spin on January 2, 20X5, when the book values and fair values of the assets and liabilities of Spin were equal, except for patents,
which had a fair value of $28,000. The fair value of the noncontrolling interest was equal to a proportionate share of fair value of Spin’s net assets.
2. What was the amount of intercompany sales from Power to Spin during 20X8?
a. $3,000
b. $6,000
c. $29,000
d. $32,000
3. At December 31, 20X8, what was the amount of Spin’s payable to Power for intercompany sales?
page 278
a. $3,000
b. $6,000
c. $29,000
d. $32,000
4. In Power’s consolidated balance sheet, what was the carrying amount of the inventory that Spin purchased from Power?
a. $3,000
b. $6,000
c. $9,000
d. $12,000
5. What is the percent of noncontrolling interest ownership of Spin?
a. 10 percent
b. 20 percent
c. 25 percent
d. 45 percent
6. Over how many years has Power chosen to amortize patents?
a. 10 years
b. 14 years
c. 23 years
d. 40 years
E6–3
Multiple-Choice Questions—Consolidated Income Statement
LO 6–3
Select the correct answer for each of the following questions.
Blue Company purchased 60 percent ownership of Kelly Corporation in 20X1. On May 10, 20X2, Kelly purchased inventory from Blue for $60,000. Kelly sold all
of the inventory to an unaffiliated company for $86,000 on November 10, 20X2. Blue produced the inventory sold to Kelly for $47,000. The companies had no other
transactions during 20X2.
1. What amount of sales will be reported in the 20X2 consolidated income statement?
a. $51,600
b. $60,000
c. $86,000
d. $146,000
2. What amount of cost of goods sold will be reported in the 20X2 consolidated income statement?
a. $36,000
b. $47,000
c. $60,000
d. $107,000
3. What amount of consolidated net income will be assigned to the controlling shareholders for 20X2?
a. $13,000
b. $26,000
c. $28,600
d. $39,000
page 279
E6–4
Multiple-Choice Questions—Consolidated Balances
LO 6–4
Select the correct answer for each of the following questions.
Lorn Corporation purchased inventory from Dresser Corporation for $120,000 on September 20, 20X1, and resold 80 percent of the inventory to unaffiliated
companies prior to December 31, 20X1, for $140,000. Dresser produced the inventory sold to Lorn for $75,000. Lorn owns 70 percent of Dresser’s voting common
stock. The companies had no other transactions during 20X1.
1. What amount of sales will be reported in the 20X1 consolidated income statement?
a. $98,000
b. $120,000
c. $140,000
d. $260,000
2. What amount of cost of goods sold will be reported in the 20X1 consolidated income statement?
a. $60,000
b. $75,000
c. $96,000
d. $120,000
e. $171,000
3. What amount of consolidated net income will be assigned to the controlling interest for 20X1?
a. $20,000
b. $30,800
c. $44,000
d. $45,000
e. $69,200
f. $80,000
4. What inventory balance will be reported by the consolidated entity on December 31, 20X1?
a. $15,000
b. $16,800
c. $24,000
d. $39,000
E6–5
Multiple-Choice Questions—Consolidated Income Statement
LO 6–3
Select the correct answer for each of the following questions.
Amber Corporation holds 80 percent of the stock of Movie Productions Inc. During 20X4, Amber purchased an inventory of snack bar items for $40,000 and
resold $30,000 to Movie Productions for $48,000. Movie Productions Inc. reported sales of $67,000 in 20X4 and had inventory of $16,000 on December 31, 20X4. The
companies held no beginning inventory and had no other transactions in 20X4.
1. What amount of cost of goods sold will be reported in the 20X4 consolidated income statement?
a. $20,000
b. $30,000
c. $32,000
d. $52,000
e. $62,000.
2. What amount of net income will be reported in the 20X4 consolidated income statement?
a. $12,000
b. $18,000
c. $40,000
d. $47,000
e. $53,000
3. What amount of income will be assigned to the noncontrolling interest in the 20X4 consolidated income statement?
page 280
a. $7,000
b. $8,000
c. $9,400
d. $10,200
e. $13,400
E6–6
Realized Profit on Intercompany Sale
LO 6–3
Planet Corporation acquired 90 percent of Saturn Company’s voting shares of stock in 20X1. During 20X4, Planet purchased 40,000 Playday doghouses for $24 each
and sold 25,000 of them to Saturn for $30 each. Saturn sold all of the doghouses to retail establishments prior to December 31, 20X4, for $45 each. Both companies
use perpetual inventory systems.
Required
a.
Give the journal entries Planet recorded for the purchase of inventory and resale to Saturn Company in 20X4.
b.
Give the journal entries Saturn recorded for the purchase of inventory and resale to retail establishments in 20X4.
c.
Give the worksheet consolidation entry(ies) needed in preparing consolidated financial statements for 20X4 to remove all effects of the intercompany sale.
E6–7
Sale of Inventory to Subsidiary
LO 6–3
Planet Corporation acquired 90 percent of Saturn Company’s voting shares of stock in 20X1. During 20X4, Planet purchased 40,000 Playday doghouses for $24 each
and sold 25,000 of them to Saturn for $30 each. Saturn sold 18,000 of the doghouses to retail establishments prior to December 31, 20X4, for $45 each. Both
companies use perpetual inventory systems.
Required
a.
Give all journal entries Planet recorded for the purchase of inventory and resale to Saturn Company in 20X4.
b.
Give the journal entries Saturn recorded for the purchase of inventory and resale to retail establishments in 20X4.
c.
Give the worksheet consolidation entry(ies) needed in preparing consolidated financial statements for 20X4 to remove the effects of the intercompany sale.
E6–8
Inventory Transfer between Parent and Subsidiary
LO 6–3
Planner Corporation owns 60 percent of Schedule Company’s voting shares. During 20X3, Planner produced 25,000 computer desks at a cost of $82 each and sold
10,000 of them to Schedule for $94 each. Schedule sold 7,000 of the desks to unaffiliated companies for $130 each prior to December 31, 20X3, and sold the remainder
in early 20X4 for $140 each. Both companies use perpetual inventory systems.
Required
a.
What amounts of cost of goods sold did Planner and Schedule record in 20X3?
b.
What amount of cost of goods sold must be reported in the consolidated income statement for 20X3?
c.
Give the worksheet consolidation entry or entries needed in preparing consolidated financial statements at December 31, 20X3, relating to the intercorporate sale
of inventory.
d.
Give the worksheet consolidation entry or entries needed in preparing consolidated financial statements at December 31, 20X4, relating to the intercorporate sale
of inventory.
e.
Give the worksheet consolidation entry or entries needed in preparing consolidated financial statements at December 31, 20X4, relating to the intercorporate sale
of inventory if the sales were upstream. Assume that Schedule produced the computer desks at a cost of $82 each and sold 10,000 desks to Planner for $94 each in
20X3, with Planner selling 7,000 desks to unaffiliated companies in 20X3 and the remaining 3,000 in 20X4.
page 281
E6–9
Income Statement Effects of Unrealized Profit
LO 6–4
Pie Bakery owns 60 percent of Slice Products Company’s stock. During 20X8, Slice produced 100,000 bags of flour, which it sold to Pie Bakery for $900,000. On
December 31, 20X8, Pie had 20,000 bags of flour purchased from Slice Products on hand. Slice prices its sales at cost plus 50 percent of cost for profit. Pie, which
purchased all its flour from Slice in 20X8, had no inventory on hand on January 1, 20X8.
Pie Bakery reported income from its baking operations of $400,000, and Slice Products reported net income of $150,000 for 20X8.
Required
a.
Compute the amount reported as cost of goods sold in the 20X8 consolidated income statement.
b.
Give the worksheet consolidation entry or entries required to remove the effects of the intercompany sale in preparing consolidated statements at the end of 20X8.
c.
Compute the amounts reported as consolidated net income and income assigned to the controlling interest in the 20X8 consolidated income statement.
E6–10
Prior-Period Unrealized Inventory Profit
LO 6–4
Pie Bakery owns 60 percent of Slice Products Company’s stock. On January 1, 20X9, inventory reported by Pie included 20,000 bags of flour purchased from Slice at
$9 per bag. By December 31, 20X9, all the beginning inventory purchased from Slice Products had been baked into products and sold to customers by Pie. There
were no transactions between Pie and Slice during 20X9.
Both Pie Bakery and Slice Products price their sales at cost plus 50 percent markup for profit. Pie reported income from its baking operations of $300,000, and
Slice reported net income of $250,000 for 20X9.
Required
a.
Compute the amount reported as cost of goods sold in the 20X9 consolidated income statement for the flour purchased from Slice in 20X8.
b.
Give the consolidation entry or entries required to remove the effects of the unrealized profit in beginning inventory in preparing the consolidation worksheet as
of December 31, 20X9.
c.
Compute the amounts reported as consolidated net income and income assigned to the controlling interest in the 20X9 consolidated income statement.
E6–11
Computation of Consolidated Income Statement Data
LO 6–3, 6–4
Player Company acquired 60 percent ownership of Scout Company’s voting shares on January 1, 20X2. During 20X5, Player purchased inventory for $20,000 and
sold the full amount to Scout Company for $30,000. On December 31, 20X5, Scout’s ending inventory included $6,000 of items purchased from Player. Also in 20X5,
Scout purchased inventory for $50,000 and sold the units to Player for $80,000. Player included $20,000 of its purchase from Scout in ending inventory on December
31, 20X5.
Summary income statement data for the two companies revealed the following:
Player Company
Sales
$ 400,000
Income from Scout
Cost of Goods Sold
Other Expenses
Scout Company
$ 200,000
20,500
$ 420,500
$ 200,000
$ 250,000
$ 120,000
70,000
35,000
Total Expenses
$(320,000)
$(155,000)
Net Income
$ 100,500
$
45,000
Required
a.
Compute the amount to be reported as sales in the 20X5 consolidated income statement.
b.
Compute the amount to be reported as cost of goods sold in the 20X5 consolidated income statement.
c.
What amount of income will be assigned to the noncontrolling shareholders in the 20X5 consolidated income statement?
d.
What amount of income will be assigned to the controlling interest in the 20X5 consolidated income statement?
E6–12
page 282
Intercompany Sales
LO 6–3, 6–4
Pistol Corporation acquired 70 percent of Scope Corporation’s voting stock on May 18, 20X1. The companies reported the following data with respect to
intercompany sales in 20X4 and 20X5:
Pistol reported operating income (excluding income from its investment in Scope) of $160,000 and $220,000 in 20X4 and 20X5, respectively. Scope reported net
income of $90,000 and $85,000 in 20X4 and 20X5, respectively.
Required
a.
Compute consolidated net income for 20X4.
b.
Compute the inventory balance reported in the consolidated balance sheet at December 31, 20X5, for the transactions shown.
c.
Compute the amount included in consolidated cost of goods sold for 20X5 relating to the transactions shown.
d.
Compute the amount of income assigned to the controlling interest in the 20X5 consolidated income statement.
E6–13
Consolidated Balance Sheet Worksheet
LO 6–3, 6–4
The December 31, 20X8, balance sheets for Pint Corporation and its 70 percent-owned subsidiary Saloon Company contained the following summarized amounts:
PINT CORPORATION AND SALOON COMPANY
Balance Sheets
December 31, 20X8
Pint
Corporation
Cash & Receivables
Saloon
Company
$ 98,000
$ 40,000
Inventory
150,000
100,000
Buildings & Equipment (net)
310,000
280,000
Investment in Saloon Company
242,000
Total Assets
$800,000
$420,000
Accounts Payable
$ 70,000
$ 20,000
Common Stock
200,000
150,000
Retained Earnings
530,000
250,000
$800,000
$420,000
Total Liabilities & Equity
Pint acquired the shares of Saloon Company on January 1, 20X7. On December 31, 20X8, assume Pint sold inventory to Saloon during 20X8 for $100,000 and Saloon
sold inventory to Pint for $300,000. Pint’s balance sheet contains inventory items purchased from Saloon for $95,000. The items cost Saloon $55,000 to produce. In
addition, Saloon’s inventory contains goods it purchased from Pint for $25,000 that Pint had produced for $15,000. Assume Saloon reported net income of $70,000
and dividends of $14,000.
Required
a.
Prepare all consolidation entries needed to complete a consolidated balance sheet worksheet as of December 31, 20X8.
b.
Prepare a consolidated balance sheet worksheet as of December 31, 20X8.
page 283
E6–14 *
Multiple Transfers between Affiliates
LO 6–5
Klon Corporation owns 70 percent of Brant Company’s stock and 60 percent of Torkel Company’s stock. During 20X8, Klon sold inventory purchased in 20X7 for
$100,000 to Brant for $150,000. Brant then sold the inventory at its cost of $150,000 to Torkel. Prior to December 31, 20X8, Torkel sold $90,000 of inventory to a
nonaffiliate for $120,000 and held $60,000 in inventory at December 31, 20X8.
Required
a.
Give the journal entries recorded by Klon, Brant, and Torkel during 20X8 relating to the intercorporate sale and resale of inventory.
b.
What amount should be reported in the 20X8 consolidated income statement as cost of goods sold?
c.
What amount should be reported in the December 31, 20X8, consolidated balance sheet as inventory?
d.
Give the consolidation entry needed at December 31, 20X8, to remove the effects of the inventory transfers.
*
Indicates that the item relates to “Additional Considerations.”
E6–15
Inventory Sales
LO 6–4
Plump Corporation holds 60 percent ownership of Slim Company. Each year, Slim purchases large quantities of a gnarl root used in producing health drinks. Slim
purchased $150,000 of roots in 20X7 and sold $40,000 of these purchases to Plump for $60,000. By the end of 20X7, Plump had resold all but $15,000 of its purchase
from Slim. Plump generated $90,000 on the sale of roots to various health stores during the year.
Required
a.
Give the journal entries recorded by Plump and Slim during 20X7 relating to the initial purchase, intercorporate sale, and resale of gnarl roots.
b.
Give the worksheet consolidation entries needed as of December 31, 20X7, to remove all effects of the intercompany transfer in preparing the 20X7 consolidated
financial statements.
E6–16
Prior-Period Inventory Profits
LO 6–4
Power Products Corporation, which sells a broad line of home detergent products, owns 75 percent of the stock of Scrub Soap Company. During 20X8, Scrub sold
soap products to Power Products for $180,000, which it had produced for $120,000. Power Products sold $150,000 of its purchase from Scrub in 20X8 and the
remainder in 20X9. In addition, Power Products purchased $240,000 of inventory from Scrub in 20X9 and resold $90,000 of the items before year-end. Scrub’s cost to
produce the items sold to Power Products in 20X9 was $160,000.
Required
a.
Give all worksheet consolidation entries needed for December 31, 20X9, to remove the effects of the intercompany inventory transfers in 20X8 and 20X9.
b.
Compute the amount of income assigned to noncontrolling shareholders in the 20X8 and 20X9 consolidated income statements if Scrub reported net income of
$350,000 for 20X8 and $420,000 for 20X9.
PROBLEMS
P6–17
Consolidated Income Statement Data
LO 6–4
Paint Corporation owns 60 percent of Stain Company’s shares. Partial 20X2 financial data for the companies and consolidated entity were as follows:
Paint Corporation
Sales
Stain Company
Consolidated Totals
$550,000
$450,000
$820,000
Cost of Goods Sold
310,000
300,000
420,000
Inventory, Dec. 31
180,000
210,000
375,000
page 284
On January 1, 20X2, Paint’s inventory contained items purchased from Stain for $75,000. The cost of the units to Stain was $50,000. All intercorporate sales during
20X2 were made by Stain to Paint.
Required
a.
What amount of intercorporate sales occurred in 20X2?
b.
How much unrealized intercompany profit existed on January 1, 20X2? On December 31, 20X2?
c.
Give the worksheet consolidation entries relating to inventory and cost of goods sold needed to prepare consolidated financial statements for 20X2.
d.
If Stain reports net income of $90,000 for 20X2, what amount of income is assigned to the noncontrolling interest in the 20X2 consolidated income statement?
P6–18
Unrealized Profit on Upstream Sales
LO 6–4
Summer Company sells all its output at 25 percent above cost. Parade Corporation purchases all its inventory from Summer. Selected information on the operations
of the companies over the past three years is as follows:
Parade acquired 60 percent of the ownership of Summer on January 1, 20X1, at underlying book value.
Required
Compute consolidated net income and income assigned to the controlling interest for 20X2, 20X3, and 20X4.
P6–19
Net Income of Consolidated Entity
LO 6–3, 6–4
Pawn Corporation acquired 70 percent of Shop Corporation’s voting stock on January 1, 20X2, for $416,500. The fair value of the noncontrolling interest was
$178,500 at the date of acquisition. Shop reported common stock outstanding of $200,000 and retained earnings of $350,000. The differential is assigned to buildings
with an expected life of 15 years at the date of acquisition.
On December 31, 20X4, Pawn had $25,000 of unrealized profits on its books from inventory sales to Shop, and Shop had $40,000 of unrealized profit on its books
from inventory sales to Pawn. All inventory held at December 31, 20X4, was sold during 20X5.
On December 31, 20X5, Pawn had $14,000 of unrealized profit on its books from inventory sales to Shop, and Shop had unrealized profit on its books of $55,000
from inventory sales to Pawn.
Pawn reported income from its separate operations (excluding income on its investment in Shop and amortization of purchase differential) of $118,000 in 20X5,
and Shop reported net income of $65,000.
Required
Compute consolidated net income and income assigned to the controlling interest in the 20X5 consolidated income statement.
P6–20
Correction of Consolidation Entries
LO 6–4
In preparing the consolidation worksheet for Pencil Corporation and its 60 percent-owned subsidiary, Stylus Company, the following consolidation entries were
proposed by Pencil’s bookkeeper:
Cash
80,000
Accounts Payable
80,000
To eliminate the unpaid balance for intercorporate inventory sales in 20X5.
Cost of Goods Sold
12,000
Income from Stylus Company
12,000
To eliminate unrealized inventory profits at December 31, 20X5.
Income from Stylus Company
Sales
140,000
140,000
To eliminate intercompany sales for 20X5.
page 285
Pencil’s bookkeeper recently graduated from Oddball University, and although the dollar amounts recorded are correct, he had some confusion in determining
which accounts needed adjustment. All intercorporate sales in 20X5 were from Stylus to Pencil, and Stylus sells inventory at cost plus 40 percent of cost. Pencil
uses the fully adjusted equity method in accounting for its ownership in Stylus.
Required
a.
What percentage of the intercompany inventory transfer was resold prior to the end of 20X5?
b.
Give the appropriate consolidation entries needed at December 31, 20X5, to prepare consolidated financial statements.
P6–21
Incomplete Data
LO 6–3, 6–4
Peace Corporation acquired 75 percent of the ownership of Symbol Company on January 1, 20X1. The fair value of the noncontrolling interest at acquisition was
equal to its proportionate share of the fair value of the net assets of Symbol. The full amount of the differential at acquisition was attributable to buildings and
equipment, which had a remaining useful life of eight years. Financial statement data for the two companies and the consolidated entity at December 31, 20X6, are as
follows:
PEACE CORPORATION AND SYMBOL COMPANY
Balance Sheet Data
December 31, 20X6
Item
Peace Corporation
Cash
$
Symbol Company
$ 45,000
$ 112,000
?
55,000
145,000
Inventory
125,000
90,000
211,000
Buildings & Equipment
400,000
240,000
680,000
(180,000)
(110,000)
(
?
$320,000
$
?
Accounts Receivable
Less: Accumulated Depreciation
Investment in Symbol Company
67,000
Consolidated Entity
)
?
Total Assets
$
Accounts Payable
$
?
86,000
$ 20,000
$
8,000
89,000
Other Payables
?
?
Notes Payable
250,000
120,000
370,000
Common Stock
120,000
60,000
120,000
Retained Earnings
172,500
112,000
172,500
Noncontrolling Interest
44,500
Total Liabilities & Equity
$
?
$320,000
$
?
PEACE CORPORATION AND SYMBOL COMPANY
Income Statement Data
For the Year Ended December 31, 20X6
Item
Sales
Income from Symbol Company
Peace Corporation
$420,000
Symbol Company
Consolidated Entity
$260,000
$650,000
32,250
Total Income
$452,250
$260,000
$650,000
Cost of Goods Sold
$310,000
$170,000
$445,000
Depreciation Expense
20,000
25,000
50,000
Interest Expense
25,000
9,500
34,500
Other Expenses
22,000
15,500
37,500
Total Expenses
($377,000)
($220,000)
Consolidated Net Income
$ 83,000
Income to Noncontrolling Interest
Controlling Interest in Net Income
($567,000)
(7,750)
$ 75,250
$ 40,000
$ 75,250
All unrealized profit on intercompany inventory sales on January 1, 20X6, were eliminated on Peace’s books. All unrealized inventory profits at December 31, 20X6,
were eliminated on Symbol’s books. Assume Peace uses the fully adjusted equity method and that Peace does not make the optional depreciation page 286
consolidation worksheet entry.
Required
a.
For the buildings and equipment held by Symbol when Peace acquired it and still on hand on December 31, 20X6, by what amount had buildings and equipment
increased in value from their acquisition to the date of combination with Peace?
b.
What amount should be reported as accumulated depreciation for the consolidated entity at December 31, 20X6 (assuming Peace does not make the optional
accumulated depreciation consolidation entry)?
c.
If Symbol reported capital stock outstanding of $60,000 and retained earnings of $30,000 on January 1, 20X1, what amount did Peace pay to acquire its ownership
of Symbol?
d.
What balance does Peace report as its investment in Symbol at December 31, 20X6?
e.
What amount of intercorporate sales of inventory occurred in 20X6?
f.
What amount of unrealized inventory profit exists at December 31, 20X6?
g.
Give the consolidation entry used in eliminating intercompany inventory sales during 20X6.
h.
What was the amount of unrealized inventory profit at January 1, 20X6?
i.
What balance in accounts receivable did Peace report at December 31, 20X6?
P6–22
Eliminations for Upstream Sales
LO 6–4
Plug Products owns 80 percent of the stock of Spark Filter Company, which it acquired at underlying book value on August 30, 20X6. At that date, the fair value of
the noncontrolling interest was equal to 20 percent of the book value of Spark Filter. Summarized trial balance data for the two companies as of December 31, 20X8,
are as follows:
On January 1, 20X8, Plug’s inventory contained filters purchased for $60,000 from Spark Filter, which had produced the filters for $40,000. In 20X8, Spark Filter spent
$100,000 to produce additional filters, which it sold to Plug for $150,000. By December 31, 20X8, Plug had sold all filters that had been on hand January 1, 20X8, but
continued to hold in inventory $45,000 of the 20X8 purchase from Spark Filter.
Required
a.
Prepare all consolidation entries needed to complete a consolidation worksheet for 20X8.
b.
Compute consolidated net income and income assigned to the controlling interest in the 20X8 consolidated income statement.
c.
Compute the balance assigned to the noncontrolling interest in the consolidated balance sheet as of December 31, 20X8.
P6–23
Multiple Inventory Transfers
LO 6–3, 6–4
Ajax Corporation purchased at book value 70 percent of Beta Corporation’s ownership and 90 percent of Cole Corporation’s ownership in 20X5. At the dates the
ownership was acquired, the fair value of the noncontrolling interest was equal to a proportionate share of book value. There are frequent intercompany page 287
transfers among the companies. Activity relevant to 20X8 follows:
For the year ended December 31, 20X8, Ajax reported $80,000 of income from its separate operations (excluding income from intercorporate investments), Beta
reported net income of $37,500, and Cole reported net income of $20,000.
Required
a.
Compute the amount to be reported as consolidated net income for 20X8.
b.
Compute the amount to be reported as inventory in the December 31, 20X8, consolidated balance sheet for the preceding items.
c.
Compute the amount to be reported as income assigned to noncontrolling shareholders in the 20X8 consolidated income statement.
P6–24
Consolidation with Inventory Transfers and Other Comprehensive Income
LO 6–3, 6–4
On January 1, 20X1, Pesto Corporation purchased 90 percent of Sauce Corporation’s common stock at underlying book value. At that date, the fair value of the
noncontrolling interest was equal to 10 percent of Sauce Corporation’s book value. Pesto uses the equity method in accounting for its investment in Sauce. The
stockholders’ equity section of Sauce at January 1, 20X5, contained the following balances:
Common Stock ($5 par)
$
400,000
Additional Paid-In Capital
200,000
Retained Earnings
790,000
Accumulated Other Comprehensive Income
Total
10,000
$1,400,000
During 20X4, Sauce sold goods costing $30,000 to Pesto for $45,000, and Pesto resold 60 percent of them prior to year-end. It sold the remainder in 20X5. Also in
20X4, Pesto sold inventory items costing $90,000 to Sauce for $108,000. Sauce resold $60,000 of its purchases in 20X4 and the remaining $48,000 in 20X5.
In 20X5, Pesto sold additional inventory costing $30,000 to Sauce for $36,000, and Sauce resold $24,000 of it prior to year-end. Sauce sold inventory costing
$60,000 to Pesto in 20X5 for $90,000, and Pesto resold $48,000 of its purchase by December 31, 20X5.
Pesto reported 20X5 income of $240,000 from its separate operations and paid dividends of $150,000. Sauce reported 20X5 net income of $90,000 and
comprehensive income of $110,000. Sauce reported other comprehensive income of $10,000 in 20X4. In both years, other comprehensive income arose from an
increase in the market value of items designated as a cash flow hedge. Sauce paid dividends of $60,000 in 20X5.
Required
a.
Compute the balance in the investment account reported by Pesto at December 31, 20X5.
b.
Compute the amount of investment income reported by Pesto on its investment in Sauce for 20X5.
c.
Compute the amount of income assigned to noncontrolling shareholders in the 20X5 consolidated income statement.
d.
Compute the balance assigned to noncontrolling shareholders in the consolidated balance sheet prepared at December 31, 20X5.
e.
Pesto and Sauce report inventory balances of $120,000 and $100,000, respectively, at December 31, 20X5. What amount should be reported as
inventory in the consolidated balance sheet at December 31, 20X5?
f.
Compute the amount reported as consolidated net income for 20X5.
g.
Prepare the consolidation entries needed to complete a consolidation worksheet as of December 31, 20X5.
P6–25
Multiple Inventory Transfers between Parent and Subsidiary
LO 6–3, 6–4
page 288
Proud Company and Slinky Company both produce and purchase equipment for resale each period and frequently sell to each other. Since Proud Company holds 60
percent ownership of Slinky Company, Proud’s controller compiled the following information with regard to intercompany transactions between the two companies
in 20X5 and 20X6:
Required
a.
Give the consolidation entries required at December 31, 20X6, to eliminate the effects of the inventory transfers in preparing a full set of consolidated financial
statements.
b.
Compute the amount of cost of goods sold to be reported in the consolidated income statement for 20X6.
P6–26
Consolidation Following Inventory Transactions
LO 6–3, 6–4
Pirate Company purchased 60 percent ownership of Ship Corporation on January 1, 20X1, for $82,800. On that date, the noncontrolling interest had a fair value of
$55,200 and Ship reported common stock outstanding of $100,000 and retained earnings of $20,000. The full amount of the differential is assigned to land to be used
as a future building site. Pirate uses the fully adjusted equity method in accounting for its ownership of Ship. On December 31, 20X2, the trial balances of the two
companies are as follows:
page 289
Ship sold inventory costing $25,500 to Pirate for $42,500 in 20X1. Pirate resold 80 percent of the purchase in 20X1 and the remainder in 20X2. Ship sold inventory
costing $21,000 to Pirate in 20X2 for $35,000, and Pirate resold 70 percent of it prior to December 31, 20X2. In addition, Pirate sold inventory costing $14,000 to Ship
for $28,000 in 20X2, and Ship resold all but $13,000 of its purchase prior to December 31, 20X2.
Assume both companies use straight-line depreciation and that no property, plant, and equipment has been purchased since the acquisition.
Required
a.
Record the journal entry or entries for 20X2 on Pirate’s books related to its investment in Ship Corporation, using the equity method.
b.
Prepare the consolidation entries needed to complete a consolidated worksheet for 20X2.
c.
Prepare a three-part consolidation worksheet for 20X2.
P6–27
Consolidation Worksheet
LO 6–3, 6–4
Plaza Corporation purchased 70 percent of Square Company’s voting common stock on January 1, 20X5, for $291,200. On that date, the noncontrolling interest had a
fair value of $124,800 and the book value of Square’s net assets was $380,000. The book values and fair values of Square’s assets and liabilities were equal except for
land that had a fair value $14,000 higher than book value. The amount attributed to goodwill as a result of the acquisition is not amortized and has not been
impaired.
On January 1, 20X9, Plaza’s inventory contained $30,000 of unrealized intercompany profits recorded by Square. Square’s inventory on that date contained $15,000
of unrealized intercompany profits recorded on Plaza’s books. Both companies sold their ending 20X8 inventories to unrelated companies in 20X9.
During 20X9, Square sold inventory costing $37,000 to Plaza for $62,000. Plaza held all inventory purchased from Square during 20X9 on December 31, 20X9.
Also during 20X9, Plaza sold goods costing $54,000 to Square for $90,000. Square continues to hold $20,000 of its purchase from Plaza on December 31, 20X9.
Assume Plaza uses the fully adjusted equity method.
Required
a.
Prepare all consolidation entries needed to complete a consolidation worksheet as of December 31, 20X9.
b.
Prepare a consolidation worksheet as of December 31, 20X9.
page 290
P6–28
Computation of Consolidated Totals
LO 6–3, 6–4
Phone Corporation owns 80 percent of Smart Company’s stock. At the end of 20X8, Phone and Smart reported the following partial operating results and inventory
balances:
Total sales
Phone
Corporation
Smart
Company
$660,000
$510,000
Sales to Smart Company
140,000
Sales to Phone Corporation
240,000
Net income
20,000
Operating income (excluding investment income from Smart)
70,000
Inventory on hand, December 31, 20X8, purchased from:
Smart Company
48,000
Phone Corporation
42,000
Phone regularly prices its products at cost plus a 40 percent markup for profit. Smart prices its sales at cost plus a 20 percent markup. The total sales reported by
Phone and Smart include both intercompany sales and sales to nonaffiliates.
Required
a.
What amount of sales will be reported in the consolidated income statement for 20X8?
b.
What amount of cost of goods sold will be reported in the 20X8 consolidated income statement?
c.
What amount of consolidated net income and income to controlling interest will be reported in the 20X8 consolidated income statement?
d.
What balance will be reported for inventory in the consolidated balance sheet for December 31, 20X8?
P6–29
Intercompany Transfer of Inventory
LO 6–3, 6–4
Pop Corporation acquired 70 percent of Soda Company’s voting common shares on January 1, 20X2, for $108,500. At that date, the noncontrolling interest had a fair
value of $46,500 and Soda reported $70,000 of common stock outstanding and retained earnings of $30,000. The differential is assigned to buildings and equipment,
which had a fair value $20,000 higher than book value and a remaining 10-year life, and to patents, which had a fair value $35,000 higher than book value and a
remaining life of five years at the date of the business combination. Trial balances for the companies as of December 31, 20X3, are as follows:
page 291
On December 31, 20X2, Soda purchased inventory for $32,000 and sold it to Pop for $48,000. Pop resold $27,000 of the inventory (i.e., $27,000 of the $48,000 acquired
from Soda) during 20X3 and had the remaining balance in inventory at December 31, 20X3.
During 20X3, Soda sold inventory purchased for $60,000 to Pop for $90,000, and Pop resold all but $24,000 of its purchase. On March 10, 20X3, Pop sold
inventory purchased for $15,000 to Soda for $30,000. Soda sold all but $7,600 of the inventory prior to December 31, 20X3. Assume Pop uses the fully adjusted
equity method, that both companies use straight-line depreciation, and that no property, plant, and equipment has been purchased since the acquisition.
Required
a.
Give all consolidation entries needed to prepare a full set of consolidated financial statements at December 31, 20X3, for Pop and Soda.
b.
Prepare a three-part consolidation worksheet for 20X3.
P6–30
Consolidation Using Financial Statement Data
LO 6–3, 6–4
Point Corporation acquired 60 percent of Stick Company’s stock on January 1, 20X3, for $24,000 in excess of book value. On that date, the book values and fair
values of Stick’s assets and liabilities were equal and the fair value of the noncontrolling interest was $16,000 in excess of book value. The full amount of the
differential at acquisition was assigned to goodwill of $40,000. At December 31, 20X6, Point management reviewed the amount assigned to goodwill and concluded
it had been impaired. They concluded the correct carrying value at that date should be $30,000 and the impairment loss should be assigned proportionately between
the controlling and noncontrolling interests.
Balance sheet data for January 1, 20X6, and December 31, 20X6, and income statement data for 20X6 for the two companies are as follows:
page 292
On January 1, 20X6, Point held inventory purchased from Stick for $48,000. During 20X6, Point purchased an additional $90,000 of goods from Stick and held
$54,000 of its purchases on December 31, 20X6. Stick sells inventory to Point Corporation at 20 percent above cost.
Stick also purchases inventory from Point. On January 1, 20X6, Stick held inventory purchased from Point for $14,000, and on December 31, 20X6, it held
inventory purchased from Point for $7,000. Stick’s total purchases from Point were $22,000 in 20X6. Point sells items to Stick at 40 percent above cost.
During 20X6, Point paid dividends of $50,000, and Stick paid dividends of $20,000. Assume that Point uses the fully adjusted equity method that both companies
use straight-line depreciation, and that no property, plant, and equipment has been purchased since the acquisition.
Required
a.
Prepare all consolidation entries needed to complete a consolidation worksheet as of December 31, 20X6.
b.
Prepare a three-part consolidation worksheet as of December 31, 20X6.
P6–31
Intercorporate Transfer of Inventory
LO 6–3, 6–4
Song Corporation was created on January 1, 20X0, to develop computer software. On January 1, 20X5, Polka Company purchased 90 percent of Song’s common
stock at underlying book value. At that date, the fair value of the noncontrolling interest was equal to 10 percent of Song’s book value. Trial balances for Polka and
Song on December 31, 20X9, are as follows:
page 293
During 20X9, Song produced inventory for $20,000 and sold it to Polka for $30,000. Polka resold 60 percent of the inventory in 20X9. Also in 20X9, Polka sold
inventory purchased from Song in 20X8. It had cost Song $60,000 to produce the inventory, and Polka purchased it for $75,000. Assume Polka uses the fully
adjusted equity method.
Required
a.
What amount of cost of goods sold will be reported in the 20X9 consolidated income statement?
b.
What inventory balance will be reported in the December 31, 20X9, consolidated balance sheet?
c.
What amount of income will be assigned to noncontrolling shareholders in the 20X9 consolidated income statement?
d.
What amount will be assigned to noncontrolling interest in the consolidated balance sheet prepared at December 31, 20X9?
e.
What amount of retained earnings will be reported in the consolidated balance sheet at December 31, 20X9?
f.
Give all consolidation entries required to prepare a three-part consolidation worksheet at December 31, 20X9.
g.
Prepare a three-part consolidation worksheet at December 31, 20X9.
P6–32
Consolidated Balance Sheet Worksheet [AICPA Adapted]
LO 6–3
The December 31, 20X6, condensed balance sheets of Pine Corporation and its 90 percent-owned subsidiary, Slim Corporation, are presented in the accompanying
worksheet.
Additional Information
1. Pine’s investment in Slim was acquired for $1,170,000 cash on January 1, 20X6, and is accounted for by the equity method. The fair value of the noncontrolling
interest at that date was $130,000.
2. At January 1, 20X6, Slim’s retained earnings amounted to $600,000, and its common stock amounted to $200,000.
3. Slim declared a $1,000 cash dividend in December 20X6, payable in January 20X7.
4. Slim borrowed $100,000 from Pine on June 30, 20X6, with the note maturing on June 30, 20X7, at 10 percent interest. Correct interest accruals have been
recorded by both companies.
5. During 20X6, Pine sold merchandise to Slim at an aggregate invoice price of $300,000, which included a profit of $60,000. At December 31, 20X6, Slim had not
paid Pine for $90,000 of these purchases, and 5 percent of the total merchandise purchased from Pine still remained in Slim’s inventory. Assume Pine page 294
uses the fully adjusted equity method.
6. Pine’s excess cost over book value of its investment in Slim has appropriately been identified as goodwill. At December 31, 20X6, Pine’s management reviewed
the amount attributed to goodwill and found no evidence of impairment.
Required
Complete the accompanying worksheet for Pine and its subsidiary, Slim, at December 31, 20X6.
P6–33
Comprehensive Consolidation Worksheet; Fully Adjusted Equity Method
[AICPA Adapted]
LO 6–4
Print Corporation acquired all outstanding $10 par value voting common stock of Size Inc. on January 1, 20X9, in exchange for 25,000 shares of its $20 par value
voting common stock. On December 31, 20X8, Print’s common stock had a closing market price of $30 per share on a national stock exchange. The acquisition was
appropriately accounted for under the acquisition method. Both companies continued to operate as separate business entities maintaining separate accounting
records with years ending December 31. Print accounts for its investment in Size stock using the fully adjusted equity method (i.e., adjusting for unrealized
intercompany profits).
On December 31, 20X9, the companies had condensed financial statements as follows:
page 295
Print Corporation
Income Statement
Net Sales
Dr
(Cr)
$(3,800,000)
Income from Size Inc.
Size Inc.
Dr
(Cr)
$(1,500,000)
(128,000)
Gain on Sale of Warehouse
(30,000)
Cost of Goods Sold
2,360,000
870,000
Operating Expenses (including depreciation)
1,100,000
440,000
Net Income
$
(498,000)
$
(190,000)
$
(440,000)
$
(156,000)
Retained Earnings Statement
Balance, 1/1/X9
Net Income
(498,000)
(190,000)
Dividends Paid
Balance, 12/31/X9
40,000
$
(938,000)
$
(306,000)
$
570,000
$
150,000
Balance Sheet
Assets:
Cash
Accounts Receivable (net)
860,000
350,000
Inventories
1,060,000
410,000
Land, Plant, & Equipment
1,320,000
680,000
Accumulated Depreciation
(370,000)
(210,000)
Investment in Size Inc.
838,000
Total Assets
$
4,278,000
$ 1,380,000
Liabilities & Stockholders’ Equity:
Accounts Payable & Accrued Expenses
Common Stock
$(1,340,000)
$
(594,000)
(1,700,000)
(400,000)
Additional Paid-In Capital
(300,000)
(80,000)
Retained Earnings
(938,000)
(306,000)
$(4,278,000)
$(1,380,000)
Total Liabilities & Equity
Additional Information
No changes occurred in the Common Stock and Additional Paid-In Capital accounts during 20X9 except the one necessitated by Print’s acquisition of Size.
At the acquisition date, the fair value of Size’s machinery exceeded its book value by $54,000. The excess cost will be amortized over the estimated average
remaining life of six years. The fair values of all of Size’s other assets and liabilities were equal to their book values. At December 31, 20X9, Print’s management
reviewed the amount attributed to goodwill as a result of its purchase of Size’s common stock and concluded an impairment loss of $35,000 should be recognized in
20X9.
During 20X9, Print purchased merchandise from Size at an aggregate invoice price of $180,000, which included a 100 percent markup on Size’s cost. At December
31, 20X9, Print owed Size $86,000 on these purchases, and $36,000 of this merchandise remained in Print’s inventory.
Required
Develop and complete a consolidation worksheet that would be used to prepare a consolidated income statement and a consolidated retained earnings statement
for the year ended December 31, 20X9, and a consolidated balance sheet as of December 31, 20X9. List the accounts in the worksheet in the same order as they are
listed in the financial statements provided. Formal consolidated statements are not required. Ignore income tax considerations. Supporting computations should be
in good form.
P6–34
Comprehensive Worksheet Problem
LO 6–3, 6–4
Prime Corporation acquired 80 percent of Steak Company’s voting shares on January 1, 20X4, for $280,000 in cash and marketable securities. At that date, the
noncontrolling interest had a fair value of $70,000 and Steak reported net assets of $300,000. Assume Prime uses the fully adjusted equity method. Trial balances for
the two companies on December 31, 20X7, are as follows:
page 296
Additional Information
1. The full amount of the differential at acquisition was assigned to buildings and equipment with a remaining 10-year economic life.
2. Prime and Steak regularly purchase inventory from each other. During 20X6, Steak Company sold inventory costing $40,000 to Prime Corporation for $60,000,
and Prime resold 60 percent of the inventory in 20X6 and 40 percent in 20X7. Also in 20X6, Prime sold inventory costing $20,000 to Steak for $26,000. Steak
resold two-thirds of the inventory in 20X6 and one-third in 20X7.
3. During 20X7, Steak sold inventory costing $30,000 to Prime for $45,000, and Prime sold items purchased for $9,000 to Steak for $12,000. Before the end of the
year, Prime resold one-third of the inventory it purchased from Steak in 20X7. Steak continues to hold all the units purchased from Prime during 20X7.
4. Steak owes Prime $10,000 on account on December 31, 20X7.
5. Assume that both companies use straight-line depreciation and that no property, plant, and equipment has been purchased since the acquisition.
Required
a.
Prepare the 20X7 journal entries recorded on Prime’s books related to its investment in Steak if Prime uses the equity method.
b.
Prepare all consolidation entries needed to complete a consolidation worksheet as of December 31, 20X7.
c.
Prepare a three-part consolidation worksheet as of December 31, 20X7.
d.
Prepare, in good form, a consolidated income statement, balance sheet, and retained earnings statement for 20X7.
P6–35A
Modified Equity Method Appendix
On December 31, 20X7, Prime Corporation recorded the following entry on its books to adjust from the fully adjusted equity method to the modified equity method
for its investment in Steak Company stock:
Investment in Steak Company Stock 11,000
Retained Earnings
8,400
Income from Steak Company
2,600
Required
a.
Adjust the data reported by Prime in the trial balance contained in P6-34 for the effects of the preceding adjusting entry.
b.
Prepare the journal entries that would have been recorded on Prime’s books during 20X7 under the modified equity method.
c.
Prepare all consolidation entries needed to complete a consolidation worksheet at December 31, 20X7, assuming Prime has used the modified equity
method.
d.
Complete a three-part consolidation worksheet as of December 31, 20X7.
P6–36A
page 297
Cost Method Appendix
The trial balance data presented in Problem P6-34 can be converted to reflect use of the cost method by inserting the following amounts in place of those presented
for Prime Corporation:
Investment in Steak Company $280,000
Retained Earnings
Income from Steak Company
Dividend Income
329,900
0
20,000
Required
a.
Prepare the journal entries that would have been recorded on Prime’s books during 20X7 under the cost method.
b.
Prepare all consolidation entries needed to complete a consolidation worksheet as of December 31, 20X7, assuming Prime uses the cost method.
c.
Complete a three-part consolidation worksheet as of December 31, 20X7.
“A” indicates that the item relates to Appendix 6A.
1
Tim Worstall, “Why Samsung Beats Apple or Perhaps Vice Versa,” Forbes, September 9, 2013; Ian Sherr, Eva
Dou, and Lorraine Luk, “Apple Tests iPhone Screens as Large as Six Inches,” The Wall Street Journal,
September 5, 2013.
2
Special rules require companies to disclose transactions with unconsolidated affiliates as related-party
transactions. These companies are not “completely independent parties who act in their own best interests,”
yet the transactions between them are included in the financial statements. The key difference is that all
transactions with consolidated subsidiaries must be eliminated.
3
Another approach, which we call the modified equity method, ignores intercompany transactions on the
parent’s books. Proponents of this method argue that worksheet consolidation entries remove the effects of
these transactions in the consolidation process anyway, so there is no need for the parent to record the
extra entries to ensure that its books are always up-to-date. Although it is true that the consolidated
financial statements are the same either way, when the modified equity method is used, key numbers in the
parent’s books (such as net income and retained earnings) will no longer equal the balances in the
consolidated financial statements. We present this alternative approach in Appendix 6A.
4
Inventory is not typically held for multiple years. However, many companies prepare quarterly consolidated
financial statements and each quarter would be considered a unique period. Also, some companies sell large
items (like cars, boats, or recreational vehicles) or expensive items (like jewelry), which may remain in
inventory for more than one quarterly or annual period. Finally, when companies report LIFO inventories, they
may build up LIFO layers, which create a fictional accounting notion that inventory items (long since sold)
are still in stock.
5
Under the equity method, the parent accounts for all transactions related to its ownership in a subsidiary
through the Investment in Subsidiary and Income from Subsidiary accounts. Even though the transaction giving
rise to the unrealized profit or loss in this situation relates to an inventory transfer, the parent defers
the unrealized profit or loss by making adjustments to the investment and Income from Subsidiary accounts.
6
7
To view a video explanation of this topic, visit advancedstudyguide.com.
As explained previously, inventory is not typically held for multiple periods, but some companies prepare
quarterly consolidated financial statements, and some companies sell large or expensive items, which may
remain in inventory for more than one period. Moreover, when companies report LIFO inventories, they may
build up LIFO layers, which create a fictional accounting notion that inventory items (long since sold) are
still in stock.
page 298
7
Intercompany Transfers of Services and
Noncurrent Assets
Multicorporate Entities
Business Combinations
Consolidation Concepts and Procedures
Intercompany Transfers
Additional Consolidation Issues
Multinational Entities
Reporting Requirements
Partnerships
Governmental and Not-for-Profit Entities
Corporations in Financial Difficulty
MICRON’S INTERCOMPANY FIXED ASSET SALE
Micron Technology Inc., founded in Boise, Idaho, in 1978, was ranked number 226 in the 2017 Fortune 500 listing, with 2016 net sales of $12.4 billion. It is
a global leader in the semiconductor industry with more than 30,000 employees and 26,000 patents. The company’s portfolio of high-performance memory
technologies includes DRAM, NAND, NOR Flash, and 3D XPoint™ memory. Over the past decade, the demand for computer memory products has led to a
surge in industrywide profits. In the third quarter of 2017, Micron announced record revenues of $4.57 billion, 20 percent higher than the second quarter of
2017 and 92 percent higher than the third quarter of fiscal 2016.
In addition to Micron’s technology innovations, its worldwide growth is also attributable to its joint ventures and strategic acquisitions. For example, in
January 2006, Micron and Intel Corporation formed a new company called IM Flash Technologies LLC, located in Lehi, Utah. A few years earlier in 2002,
Micron acquired Toshiba’s commodity DRAM operations, now a wholly owned subsidiary, located in Manassas, Virginia.
In June 2009, IM Flash Technologies sold underutilized semiconductor manufacturing equipment to Micron Technology in Manassas, Virginia. The
equipment originally cost $3,673,962; at that time, it was assigned a five-year useful life. Because it had been depreciated for only about 25 months of its
expected 60-month useful life, IM Flash Technologies determined that the equipment had a book value of $2,439,888 at the time of the transfer.
Given the agreed-upon fair market value and selling price of $1,500,000, IM Flash Technologies realized a loss of $939,888 on this intercompany asset
sale. Because Micron Technology Inc. owns more than 50 percent of IM Flash Technologies and 100 percent of Micron Technology in Manassas, Virginia, it
consolidated both companies. Therefore, the loss on this sale between affiliated companies had to be eliminated in the consolidation process. This chapter
explores the accounting for both depreciable and nondepreciable asset transfers among affiliated companies.
page 299
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO 7–1
Understand and explain concepts associated with transfers of services and long-term assets.
LO 7–2
Prepare simple equity-method journal entries related to an intercompany land transfer.
LO 7–3
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following a downstream land
transfer.
LO 7–4
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following an upstream land
transfer.
LO 7–5
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following a downstream depreciable
asset transfer.
LO 7–6
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following an upstream depreciable
asset transfer.
INTERCOMPANY TRANSFERS OF SERVICES
L O 7 –1
Understand and explain concepts associated with transfers of services and long-term assets.
Related companies frequently purchase services from one another. These services may be of many different types; common types include intercompany
purchases of consulting, engineering, marketing, and maintenance services.
When one company purchases services from a related company, the purchaser typically records an expense and the seller records revenue. When
consolidated financial statements are prepared, both the revenue and the expense must be eliminated. For example, if the parent sells consulting services to
the subsidiary for $50,000, the parent would recognize $50,000 of consulting revenue on its books and the subsidiary would recognize $50,000 of consulting
expense. In the consolidation worksheet, a consolidation entry would be needed to reduce both consulting revenue (debit) and consulting expense (credit) by
$50,000. Because the revenue and expense are equal and both are eliminated, income is unaffected by the consolidation. Even though income is not affected,
the consolidation is still important because otherwise both revenues and expenses are overstated.
Generally, a simplistic approach is appropriate in eliminating intercompany transfers of services by assuming that the services benefit the current period
and, therefore, any intercompany profit on the services becomes realized within the period of transfer. Accordingly, no consolidation entries relating to the
current period’s transfer of services are needed in future periods because the intercompany profit is considered realized in the transfer period.
Usually the assumption that the profit on intercompany sales of services is realized in the period of sale is realistic. In some cases, however, realization of
intercompany profit on the services does not occur in the period the services are provided, and the amounts are significant. For example, if the parent
company charges a subsidiary for architectural services to design a new manufacturing facility for the subsidiary, the subsidiary would include that cost in
the capitalized cost of the new facility. From a consolidated point of view, however, any profit the parent recognized on the intercompany sale of services
(revenue over the cost of providing the service) would have to be eliminated from the reported cost of the new facility until the intercompany profit became
realized. Realization would be viewed as occurring over the life of the facility. Thus, consolidation entries would be needed each year similar to those
illustrated later in the chapter for intercompany fixed asset transfers.
page 300
INTERCOMPANY LONG-TERM ASSET TRANSFERS
The following illustrations provide an overview of the intercompany sale process using land as an example. Figure 7–1 presents a series of transactions
involving a parent company and its subsidiary. First, Parent Company purchases land from an unrelated party. Then Parent Company sells the land to a
subsidiary. Finally, the subsidiary sells the land to an unrelated party. The three transactions, and the amounts, are
T1—Parent Company purchases land from an independent third party for $10,000.
T2—Parent Company sells the land to Subsidiary Corporation for $15,000.
T3—Subsidiary Corporation sells the land to an independent third party for $25,000.
F I G U R E 7 –1
Intercompany Sales
As illustrated in the following independent cases, the amount of gain reported by each of the individual companies and by the consolidated entity in each
accounting period depends on which transactions actually occur during that period.
Case A
Assume that all three transactions are completed in the same accounting period. The gain amounts reported on the transactions are
Parent Company
$ 5,000 ($15,000 − $10,000)
Subsidiary Corporation
10,000 ($25,000 − $15,000)
Consolidated Entity
15,000 ($25,000 − $10,000)
The gain on the sale of the land is considered to be realized because it is resold to an unrelated party during the period. The total gain that the consolidated
entity reports is the difference between the $10,000 price it paid to an unaffiliated seller and the $25,000 price at which it sells the land to an unaffiliated
buyer. This $15,000 gain is reported in the consolidated income statement. From a consolidated viewpoint, the sale from Parent Company to Subsidiary
Corporation, transaction T2, is an internal transaction and is not reported in the consolidated financial statements.
Case B
Assume that only transaction T1 is completed during the current period. The gain amounts reported on the transactions are
Parent Company
$0
Subsidiary Corporation
0
Consolidated Entity
0
Neither of the affiliated companies has made a sale, and no gains are reported or realized. The land is reported both in Parent Company’s balance sheet
and in the consolidated balance sheet at its cost to Parent, which also is the cost to the consolidated entity.
page 301
Case C
Assume that only transactions T1 and T2 are completed during the current period. The gain amounts reported on the transactions are
Parent Company
$ 5,000
Subsidiary Corporation
0
Consolidated Entity
0
($15,000 − $10,000)
The $5,000 gain reported by Parent Company is considered unrealized from a consolidated point of view and is not reported in the consolidated income
statement because the land has not been resold to a party outside the consolidated entity. Subsidiary Corporation’s books carry the land at $15,000, the cost
to Subsidiary. From a consolidated viewpoint, the land is overvalued by $5,000 and must be reduced to its $10,000 cost to the consolidated entity.
Case D
Assume that only transaction T3 is completed during the current period and that T1 and T2 occurred in a prior period. The gain amounts reported on the
transactions in the current period are
Parent Company
$
0
Subsidiary Corporation 10,000 ($25,000−$15,000)
Consolidated Entity
15,000 ($25,000−$10,000)
Subsidiary recognizes a gain equal to the difference between its selling price, $25,000, and cost, $15,000, and the consolidated entity reports a gain equal to
the difference between its selling price of $25,000 and the cost to the consolidated entity from an outsider of $10,000.
From a consolidated viewpoint, the sale of an asset wholly within the consolidated entity involves only a change in the technical owner of the asset and
possibly its location and does not represent the culmination of the earning process. To culminate the earning process with respect to the consolidated entity, it
must make a sale to a party external to the consolidated entity. The key to deciding when to report a transaction in the consolidated financial statements is to
visualize the consolidated entity and determine whether a particular transaction (1) occurs totally within the consolidated entity, in which case its effects must
be excluded from the consolidated statements, or (2) involves outsiders and thus constitutes a transaction of the consolidated entity.
INTERCOMPANY LAND TRANSFERS 1
When intercompany transfers of noncurrent assets occur, the parent company must make adjustments in the preparation of consolidated financial statements
for as long as the acquiring company holds the assets. The simplest example of an intercompany asset transfer is the intercompany sale of land.
L O 7 –2
Prepare simple equity-method journal entries related to an intercompany land transfer.
Overview of the Profit Consolidation Process
When related companies transfer land at book value, no special adjustments are needed in preparing the consolidated statements. If, for example, a company
purchases land for $10,000 and sells it to its subsidiary for $10,000, the asset continues to be valued at the $10,000 original cost to the consolidated entity:
page 302
Because the seller records no gain or loss, both income and assets are stated correctly from a consolidated viewpoint.
Land transfers at more or less than book value require special treatment. Under the fully adjusted equity method, the parent company must defer any
unrealized gains or losses until the assets are eventually sold to unrelated parties. Moreover, in the consolidation process, the selling entity’s gain or loss must
be eliminated because the consolidated entity still holds the land, and no gain or loss may be reported in the consolidated financial statements until the land is
sold to a party outside the consolidated entity. Likewise, the land must be reported at its original cost in the consolidated financial statements as long as it is
held within the consolidated entity, regardless of which affiliate holds the land.
As an illustration, assume that Peerless Products Corporation acquires land for $20,000 on January 1, 20X1, and sells the land to its subsidiary, Special
Foods Incorporated, on July 1, 20X1, for $35,000, as follows:
Peerless records the purchase of the land and its sale to Special Foods with the following entries:
January 1, 20X1
(1)
Land
20,000
Cash
20,000
Record land purchase.
July 1, 20X1
(2)
Cash
35,000
Land
20,000
Gain on Sale of Land
15,000
Record sale of land to Special Foods.
Special Foods records the purchase of the land from Peerless as follows:
July 1, 20X1
(3)
Land
35,000
Cash
35,000
Record purchase of land from Peerless.
The intercompany transfer leads to a $15,000 gain on Peerless’s books, and the carrying value of the land increases by the same amount on Special Foods’
books. Neither of these amounts may be reported in the consolidated financial statements because the $15,000 intercompany gain is unrealized from a
consolidated viewpoint. The land has not been sold to a party outside the consolidated entity but has only been transferred within it; consequently, the land
must still be reported in the consolidated financial statements at its original cost to the consolidated entity.
When intercompany gains or losses on asset transfers occur, the parent company can choose to use the fully adjusted equity method, which requires it to
adjust its investment and income from subsidiary accounts to remove the unrealized gain.
July 1, 20X1
(4)
Income from Special Foods
Investment in Special Foods Stock
15,000
15,000
Defer gain on intercompany land sale to Special Foods.
page 303
This equity-method entry ensures that the parent company’s income is exactly equal to the controlling interest in consolidated income on the consolidated
financial statements. Chapter 6 explains that the deferral of unrealized gross profit on intercompany inventory transfers is reversed in the subsequent
accounting period if the inventory is sold to an outside party. Similarly, the deferral of gain on an intercompany asset transfer is reversed in the period in
which the asset is sold to an outsider (which may or may not be in the very next period).
FYI
Students sometimes ask if this entry “double-counts” the deferral of the gain because the gain is also
eliminated in the consolidation worksheet. Note that this equity-method entry defers the gain on the
parent’s books to ensure that the parent’s net income is accurate and equal to the parent’s share of
consolidated net income. Although the parent company records this deferral in its books, the investment in
subsidiary and income from subsidiary accounts are eliminated in the consolidation process (i.e., they do
not show up in the consolidated financial statements). Thus, a worksheet entry is still necessary to
ensure that the gain is removed from the consolidated financial statements. This explanation will be
clearer in subsequent examples where we present the full consolidation worksheet.
We use the fully adjusted equity method in all subsequent examples in the chapter. Another option is to ignore this unrealized gain on the parent
company’s books and adjust for it in the consolidation worksheet only under the modified equity method. We illustrate this approach in the appendix.
In the consolidation process, the gain should be eliminated and the land restated from the $35,000 recorded on Special Foods’ books to its original cost of
$20,000. This is accomplished with the following entry in the consolidation worksheet prepared at the end of 20X1:
Gain on Sale of Land
15,000
Land
15,000
Assignment of Unrealized Profit Consolidation
Unrealized intercompany gains and losses must be eliminated fully when preparing consolidated financial statements. Regardless of the parent’s percentage
ownership of a subsidiary, the full amount of any unrealized gains and losses must be eliminated and must be excluded from consolidated net income.
Although the full amount of an unrealized gain or loss is excluded from consolidated net income, a question arises when the parent owns less than 100
percent of a subsidiary as to whether the unrealized profit consolidation should reduce the controlling or noncontrolling interest, or both.
A gain or loss on an intercompany transfer is recognized by the selling affiliate and ultimately accrues to the stockholders of that affiliate. When a parent
sells to a subsidiary, referred to as a downstream sale, any gain or loss on the transfer accrues to the parent company’s stockholders. When a subsidiary sells
to its parent, an upstream sale, any gain or loss accrues to the subsidiary’s stockholders. If the subsidiary is wholly owned, all gain or loss ultimately accrues
to the parent company as the sole stockholder. If, however, the selling subsidiary is not wholly owned, the gain or loss on the upstream sale is apportioned
between the parent company and the noncontrolling shareholders.
Generally, the consolidated entity does not consider gains and losses realized until a sale is made to an unrelated, external party. Unrealized gains and
losses are eliminated in preparing consolidated financial statements against the interests of those shareholders who recognized the gains and losses in the first
place—the shareholders of the selling affiliate. Therefore, the direction of the sale determines which shareholder group absorbs the consolidation of
unrealized intercompany gains and losses. Thus, unrealized intercompany gains and losses are eliminated in consolidation in the following ways:
Sale
Downstream (parent to subsidiary)
Consolidation
Against controlling interest
Upstream (subsidiary to parent):
Wholly owned subsidiary
Against controlling interest
Majority-owned subsidiary
Proportionately against controlling and noncontrolling interests
page 304
As an illustration, assume that Purity Company owns 75 percent of the common stock of Southern Corporation. Purity reports operating income of
$100,000 from its own activities, excluding any investment income from or transactions with Southern; Southern reports operating income of $50,000,
exclusive of any gains or losses on asset transfers. In each example, assume the selling affiliate has a separate unrealized gain of $10,000 on the
intercompany transfer of an asset. In the case of a downstream transfer, all unrealized profit is eliminated from the controlling interest’s share of income
when consolidated statements are prepared. Thus, the controlling interest in consolidated net income is computed as follows:
Southern’s reported net income
$ 50,000
Purity’s ownership percentage
× 0.75
Purity’s share of Southern’s reported income
37,500
Less: Purity’s 100% deferral of the unrealized downstream intercompany gain
(10,000)
Purity’s income from Southern
27,500
Purity’s separate income (including downstream intercompany gain)
Income to controlling interest
110,000
$137,500
If, instead, the intercompany transfer is upstream from subsidiary to parent, the unrealized profit on the upstream sale is eliminated proportionately from
the interests of the controlling and noncontrolling shareholders. In this situation, the controlling interest in consolidated net income is computed as follows:
Southern’s operating income
$ 50,000
Upstream intercompany gain
10,000
Southern’s reported net income
60,000
Purity’s ownership percentage
× 0.75
Purity’s share of Southern’s reported income
45,000
Less: Purity’s 75% deferral of the upstream unrealized intercompany gain
(7,500)
Purity’s income from Southern
37,500
Purity’s separate income
100,000
Income to controlling interest
$137,500
Consolidated net income ($150,000) and the controlling interest in consolidated net income ($137,500) are the same whether the intercompany sale is
upstream or downstream, but the allocation of the deferral differs. Because Purity recognized all the gain in the downstream case, the controlling interest’s
share of income is reduced by the full unrealized gain consolidation. In the upstream case, the intercompany gain was recognized by Southern and shared
proportionately by Southern’s controlling and noncontrolling interests. Therefore, the consolidation is made proportionately against the controlling and
noncontrolling interests’ share of income.
Note that unrealized intercompany gains and losses are always fully eliminated in preparing consolidated financial statements. The existence of a
noncontrolling interest in a selling subsidiary only affects the allocation of the deferral of the unrealized gain or loss, not the amount deferred.
Income to the Noncontrolling Interest
The income assigned to the noncontrolling interest is the noncontrolling interest’s proportionate share of the subsidiary’s reported net income realized in
transactions with parties external to the consolidated entity. Income assigned to the noncontrolling interest in the downstream example is computed as
follows:
Southern’s reported net income
NCI’s percentage
Income to NCI
$50,000
×0.25
$12,500
page 305
Income assigned to the noncontrolling interest in the upstream example is computed as follows:
Southern’s reported income (including intercompany gain)
NCI’s ownership percentage
$60,000
×0.25
NCI’s share of Southern’s reported income
$15,000
Less: NCI’s 25% deferral of the upstream unrealized intercompany gain
(2,500)
Income to NCI
$12,500
In the downstream example, the $10,000 of unrealized intercompany profit is recognized on the parent company’s books; therefore, the noncontrolling
interest is not affected by the unrealized gain on the downstream intercompany transaction. The entire $50,000 of the subsidiary’s income is realized in
transactions with parties external to the consolidated entity. In the upstream example, the subsidiary’s income includes $10,000 of unrealized intercompany
profit. The amount of the subsidiary’s income realized in transactions with external parties is only $50,000 ($60,000 less $10,000 of unrealized intercompany
profit).
Downstream Land Sale — Comprehensive Three-Year Example
L O 7 –3
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following a downstream land transfer.
As we did in Chapter 6, we return to the example of Peerless Products Corporation and Special Foods Inc. from Chapter 3, this time to illustrate the entries
and consolidation process for a three-year period of time. We assume the following with respect to the Peerless Products and Special Foods example
presented previously:
Peerless Products Corporation purchases 80 percent of Special Foods Inc.’s stock on December 31, 20X0, at
the stock’s book value of $240,000. The fair value of Special Foods’ noncontrolling interest on that date is
$60,000, the book value of those shares.
Peerless Products accounts for its investment in Special Foods using the equity method under which it records
its share of Special Foods’ net income and dividends and also adjusts for unrealized intercompany profits using
the fully adjusted equity method.
For our illustration, we will look at a set of transactions involving the intercompany sale of land where Peerless Products purchases land in 20X1 and sells
the land to Special Foods later in the same year. Special Foods then sells the land to a nonaffiliated party in 20X3. These transactions can be summarized as
follows:
Year 1—Downstream Land Sale
For our illustration, assume the following for Year 1:
1. Peerless Products reports separate income of $140,000 from regular operations and declares dividends of $60,000.
2. Special Foods reports net income of $50,000 and declares dividends of $30,000.
3. Peerless Products purchases land on January 1, 20X1, for $20,000 and sells the land to Special Foods for $35,000 on July 1, 20X1. Special Foods continues to hold
this land as of December 31, 20X1.
page 306
Entries for Purchase and Sale of Land—20X1
Peerless records the purchase of the land and its sale to Special Foods with the following entries:
January 1, 20X1
(5)
Land
20,000
Cash
20,000
Record land purchase.
July 1, 20X1
(6)
Cash
35,000
Land
20,000
Gain on Sale of Land
15,000
Record sale of land to Special Foods.
Special Foods records the purchase of the land from Peerless with the following entry:
(7)
Land
35,000
Cash
35,000
Record purchase of land from Peerless Products.
Equity-Method Entries—20X1
During 20X1, Peerless records its share of Special Foods’ income and dividends with the usual fully adjusted equity-method entries:
(8)
Investment in Special Foods
40,000
Income from Special Foods
40,000
Record Peerless’ 80% share of Special Foods’ 20X1 income.
(9)
Cash
Investment in Special Foods
24,000
24,000
Record Peerless’ 80% share of Special Foods’ 20X1 dividend.
The downstream sale of land to Special Foods results in a $15,000 unrealized gain. Under the fully adjusted equity method, this requires Peerless Products to
record an entry which reduces Income from Special Foods on the income statement and also reduces Investment in Special Foods on the balance sheet,
where both accounts are reduced by Peerless’s share of the unrealized gain. As this is a downstream transaction, the sale (and associated unrealized gain)
resides only on Peerless’s income statement. Because we assume the NCI shareholders do not own Peerless stock, they do not share in the deferral of the
unrealized gain.
Under the fully adjusted equity method, Peerless Products defers the entire $15,000 using the following equity-method entry:
(10)
Income from Special Foods
Investment in Special Foods
15,000
15,000
Defer gain on intercompany land sale to Special Foods.
page 307
Note that this entry accomplishes two important objectives. First, because Peerless’s income is overstated by $15,000, the adjustment to Income from
Special Foods offsets this overstatement so that Peerless’s bottom-line net income is now correct. Second, Special Foods’ land account is currently
overstated by $15,000 (because the land was originally acquired by Peerless for $20,000, but it is now recorded at $35,000 on Special Foods’ books).
Because the Investment in Special Foods account summarizes Peerless’s investment in Special Foods’ balance sheet, this reduction to the investment account
offsets the fact that Special Foods’ land (and thus entire balance sheet) is overstated by $15,000. Thus, after making this equity-method adjustment to defer
the unrealized gain on the sale of land, Peerless’s financial statements are now correctly stated. Therefore, Peerless’s reported income will be exactly equal to
the controlling interest in net income on the consolidated financial statements. This can be confirmed by comparing the ending balances shown below in the
T-accounts for Investment in Special Foods ($241,000) and Income from Special Foods ($25,000), with the amounts shown in the column for Peerless’s
financial statements in the Consolidation Worksheet in Figure 7–2.
Consolidation Entries—20X1
The calculations for the basic consolidation entry are similar to calculations we made in Chapter 3. In the Book Value Calculations panel below, we show all
of Special Foods’ equity accounts on the right side of the panel. On the left side of the calculations panel, we then allocate 80 percent of these amounts to
Peerless and 20 percent of these amounts to NCI. This is the same book value calculation we made in Chapter 3.
The adjustments contained in the Adjustment to Basic Consolidation Entry panel are created following a process similar to the one we followed to make
the adjustments in Chapter 6. Again, in cases where the parent has made an equity method entry to defer unrealized profit due to an intercompany
transaction with a subsidiary, we need to make an adjustment to the basic consolidation entry to adjust for this deferred profit. In 20X1, Peerless
recorded entry (10) above to defer $15,000 of gross profit from the intercompany transfer of land to Special Foods. Therefore, in the second panel below,
we make the adjustment to defer this $15,000 of gross profit and also to adjust the entry for the ending book value of the investment by this same amount.
The amounts highlighted in the calculations below form the basic consolidation entry which is shown. Note that the descriptions for the line item to eliminate
income from Special Foods and the line item to eliminate investment in Special Foods now include the description “with adjustments.”
page 308
The entry to adjust the accumulated depreciation is the same as in previous chapters. It is always the amount of the subsidiary’s accumulated depreciation
on the acquisition date.
The final consolidation entry needed in 20X1 eliminates the gain on the intercompany sale of land and adjusts the land back to the balance sheet value
before the transfer occurred. Although Peerless recorded an equity-method entry to defer the unrealized gain on the sale of land, both the Income from
Special Foods and Investment in Special Foods accounts are eliminated with the basic consolidation entry. Therefore, based on the remaining numbers
appearing in the trial balance, which still include the gain on sale of land, Peerless’s income is overstated by the $15,000 gain. Moreover, Special Foods’ land
account is still overstated by $15,000. Simply totaling the Peerless and Special Foods columns of the consolidation worksheet will result in overstated
consolidated net income, total assets, and retained earnings. Therefore, we also record an entry to correct the unadjusted totals to the appropriate
consolidated amounts. In doing so, consolidated income is reduced by $15,000 when the gain is eliminated. In addition, land reported on Special Foods’
books is stated at the intercompany sale price rather than the historical cost to the consolidated entity. Until the land is resold to an external party by Special
Foods, its carrying value must be reduced by the amount of unrealized intercompany gain each time consolidated statements are prepared.
Eliminate Gain on Sale of Land to Special Foods:
Gain on Sale of Land
Land
15,000
15,000
Because the land is still held within the consolidated entity, the $15,000 gain recognized on Peerless’s books must be eliminated in the consolidation
worksheet so that it does not appear in the consolidated income statement. Similarly, the land must appear in the consolidated balance sheet at its $20,000
original cost to the consolidated entity and, therefore, must be reduced from the $35,000 amount recorded on Special Foods’ books.
The T-accounts below show the balance in Peerless’s accounts on December 31, 20X1, after Peerless recorded all equity method entries. The Taccounts also illustrate how these ending balances are fully eliminated by the basic consolidation entry shown above.
page 309
In summary, when Peerless defers the unrealized gain in the equity method accounts, the $15,000 decrease in the Income from Special Foods account
offsets the gain on Peerless’s books so that Peerless’s income is correct (and equal to the controlling interest in consolidated net income). Moreover, because
the Investment in Special Foods account summarizes the entire balance sheet of Special Foods, the $15,000 decrease in the investment account offsets the
fact that the land account is overstated by $15,000 on Special Foods’ books. The following illustration shows how the internal sale of the land and the
deferral on Peerless’s books affect the accounting equation.
In looking at the diagram of the accounting equations above, it is helpful to identify the source of the amounts listed. For Peerless, both the −$15,000 in
Investment in Subsidiary and the −$15,000 in Income from Subsidiary accounts come from the equity method entry (10) above that Peerless recorded in
20X1 which reduced both accounts. The +$15,000 gain in Peerless’s Equity column comes from the $15,000 gain from sale of land that Peerless also
recorded in 20X1 in (6) above. The +$15,000 in Special Foods’ Assets column represents the difference in the land on Special Foods’ balance sheet of
$35,000 compared to the value of the land on Peerless’s balance sheet of $20,000 on July 1, 20X1, when Peerless sold the land to Special Foods.
A Key Observation from the diagram is to note that both the $15,000 gain from sale of land and the $15,000 decrease in income from subsidiary that
Peerless recorded will be closed out to Peerless’s retained earnings account where they will effectively offset each other. There will be no financial statement
impacts to carry forward from these two entries. However, the $15,000 decrease in investment in subsidiary that Peerless recorded as well as the $15,000
difference that Special Foods recorded in the value of the land will both roll forward to future years. These two items are balance sheet amounts that the
respective parties recorded in 20X1, so they will be present in the 20X2 beginning balances for the respective companies.
Consolidation Worksheet—20X1
Figure 7–2 presents the 20X1 consolidation worksheet prepared on December 31, 20X1. The consolidation entries presented above have been recorded in the
appropriate debit and credit columns under the Consolidated Entries heading.
Consolidated Net Income
The 20X1 consolidated net income is computed and allocated as follows:
Peerless’s separate income
$155,000
Less: Unrealized intercompany gain on downstream land sale
(15,000)
Peerless’s separate realized income
$140,000
Special Foods’ net income
50,000
Consolidated net income, 20X1
$190,000
Income to noncontrolling interest ($50,000 × 0.20)
(10,000)
Income to controlling interest
$180,000
page 310
Noncontrolling Interest
The noncontrolling stockholders’ share of consolidated net income is limited to their proportionate share of the subsidiary’s income. Special Foods’ net
income for 20X1 is $50,000, and the noncontrolling stockholders’ ownership interest is 20 percent. Therefore, income of $10,000 ($50,000 × 0.20) is
allocated to the noncontrolling interest.
As shown in Figure 7–2, the total noncontrolling interest in net assets at the end of 20X1 is $64,000. Normally, the noncontrolling interest’s claim on the
subsidiary’s net assets at a particular date is equal to a proportionate share of the subsidiary’s book value and remaining differential at that date. In this
example, the subsidiary’s acquisition-date fair value and book value are equal, and, thus, no differential is associated with the combination. Accordingly, the
noncontrolling interest on December 31, 20X1, is equal to a proportionate share of Special Foods’ book value:
Book value of Special Foods, December 31, 20X1:
Common stock
$200,000
Retained earnings
120,000
Total book value
$320,000
Noncontrolling stockholders’ proportionate share
Noncontrolling interest, December 31, 20X1
F I G U R E 7 –2
×0.20
$ 64,000
December 31, 20X1, Consolidation Worksheet, Period of Intercompany Sale; Downstream Sale of Land
page 311
The noncontrolling interest is unaffected by the unrealized gain on the downstream sale.
Year 2—Subsidiary Holds Land
As a continuation of our illustration of the effects of a downstream land sale, assume that Peerless Products and Special Foods had similar operating results
in 20X2 as they had in 20X1. Specifically, assume the following for Year 2:
1. During 20X2, Peerless reports separate income of $140,000 from regular operations and declares dividends of $60,000.
2. Special Foods reports net income of $50,000 and declares dividends of $30,000.
3. As of December 31, 20X2, Special Foods continues to hold the land it purchased from Peerless in 20X1.
Equity-Method Entries—20X2
During 20X2, Peerless records its share of Special Foods’ income and dividends with the usual fully adjusted equity-method entries:
(11)
Investment in Special Foods
40,000
Income from Special Foods
40,000
Record Peerless’s 80% share of Special Foods’ 20X2 income.
(12)
Cash
Investment in Special Foods
24,000
24,000
Record Peerless’s 80% share of Special Foods’ 20X2 dividend.
Consolidation Entries—20X2
In 20X2, we use the same approach for the basic consolidation entry computations that we used in 20X1. The Book Value Calculations panel shows all of
Special Foods’ equity accounts on the right side of the panel. On the left side of the calculations panel, we then allocate 80 percent of these amounts to
Peerless and 20 percent of these amounts to NCI. Since no gross profits were deferred in 20X2, and since the gross profit that was deferred in 20X1 was
not reversed in 20X2, we do not make any adjustment to the basic consolidation entry in 20X2. For clarity and consistency, the descriptions for the line item
amounts to eliminate income from Special Foods and investment in Special Foods are labeled as “with no adjustment.”
page 312
A Key Observation from the calculations for the basic consolidation entry is that the right side of the book value calculations is based on the Special
Foods’ equity accounts. However, because of the equity method entry (10) that Peerless made in 20X1, Peerless’s ending balance in the Investment in
Subsidiary account is $241,000. Correspondingly, Peerless’s beginning balance in the Investment in Subsidiary account in 20X2 is also $241,000. But, since
the right side of the book value calculations is based on Special Foods’ equity accounts, the calculation assumes that Peerless’s beginning balance in the
Investment in Subsidiary account is $256,000. The difference is the $15,000 credit that Peerless recorded in this account with the equity adjustment in entry
(10) above. Because of this difference, the Investment in Subsidiary account is sometimes referred to as being artificially low by the amount of gain that has
been deferred and not yet reversed. This difference can be observed in the diagram below where the “Investment” is shown as “−15,000” which indicates
the balance is lower by $15,000 because of deferred gain that has been deferred but not yet reversed.
When Peerless deferred the gain in entry (10) on its books in the year of the internal asset sale, 20X1, the decrease in income from Special Foods offset
the gain from Sale of Land on Peerless’s own books. When the gain and the income from Special Foods accounts were closed out to retained earnings, the
gain was offset against the artificially low income from Special Foods balance. Hence, Peerless’s retained earnings at the end of the year of the internal land
sale is correct. The following illustration shows that the subsequent year 20X2 Special Foods’ land account is still overvalued and that Peerless’s Investment
in Special Foods account is still artificially low by the $15,000 deferral.
Each period after the equity deferral entry (10) while the purchasing affiliate holds the asset, the reported asset balance and the shareholder claims of the
selling affiliate are adjusted to remove the effects of the unrealized gain or loss. Income in those subsequent periods is not affected. For example, if Special
Foods continues to hold the land purchased from Peerless Products, the following consolidation entry is needed in the consolidation worksheet each time a
consolidated balance sheet is prepared for years following the year of intercompany sale, for as long as the land is held:
Investment in Special Foods 15,000
Land
15,000
This consolidation entry simply corrects the balance in both the Land and Investment in Special Foods accounts. No income statement adjustments are
needed in the periods following the intercompany sale until the land is resold to parties external to the consolidated entity.
The T-accounts below show the balances in Peerless’s accounts on December 31, 20X2. The T-accounts also illustrate how these ending balances are
fully eliminated by the basic consolidation entry and the additional consolidation entry shown above.
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The final consolidation entry is to adjust the accumulated depreciation as in previous examples. This entry is to adjust the subsidiary’s accumulated
depreciation on the acquisition date.
Consolidation Worksheet—20X2
Figure 7–3 presents the 20X2 Consolidation Worksheet prepared on December 31, 20X2. The consolidation entries presented above have been included in
this worksheet.
Year 3—Land Sold to Nonafilliated Party
For the final year in our illustration of the effects of a downstream land sale, assume the following for Year 3:
1. During 20X3, Peerless reports separate income of $140,000 from regular operations and declares dividends of $60,000.
2. Special Foods reports 20X3 net income of $60,000 from separate operations and declares dividends of $30,000.
3. On March 1, 20X3, Special Foods sold the land it had purchased from Peerless for $35,000 on January 1, 20X1, to an unaffiliated party for a price of $45,000. Special
Foods reported a $10,000 gain from the sale of land. This gain is included in Special Foods’ $60,000 net income amount listed above.
Equity-Method Entries—20X3
During 20X3, Peerless records its share of Special Foods’ income and dividends with the usual fully adjusted equity-method entries:
(13)
Investment in Special Foods
48,000
Income from Special Foods
48,000
Record Peerless’s 80% share of Special Foods’ 20X3 income.
(14)
Cash
Investment in Special Foods
24,000
24,000
Record Peerless’s 80% share of Special Foods’ 20X3 dividend.
Unrealized profits on intercompany sales of assets are viewed as being realized at the time the assets are resold to external parties. When a transferred
asset is subsequently sold to an external party, the gain or loss recognized by the affiliate selling to the external party must be adjusted for consolidated
reporting by the amount of the previously unrealized (and deferred) intercompany gain or loss. Although the seller’s reported profit on the external sale is
based on that affiliate’s cost, the gain or loss reported by the consolidated entity is based on the cost of the asset to the consolidated entity, which is the cost
incurred by the affiliate that purchased the asset originally from an outside party.
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F I G U R E 7 –3
December 31, 20X2, Consolidation Worksheet, Period of Intercompany Sale; Downstream Sale of Land
In our example, Peerless purchased land from an unaffiliated entity for $20,000 on January 1, 20X1. Peerless then sold this land to Special Foods for
$35,000 on July 1, 20X1. This resulted in a $15,000 unrealized gain because this was an intercompany transaction, and therefore Peerless made the equity
entry (10) above in 20X1 to defer the full amount of this gain.
page 315
On March 1, 20X3, Special Foods recognizes a gain on the sale to the outside party of $10,000 ($45,000 − $35,000). From a consolidated viewpoint,
however, the gain is $25,000, the difference between the price at which the land left the consolidated entity ($45,000) and the price at which the land entered
the consolidated entity ($20,000) when it was originally purchased by Peerless. In 20X3 when the land is sold to a unaffiliated entity, Peerless records an
equity-method entry on its books to reverse the original deferral entry (10).
(15)
Investment in Special Foods
Income from Special Foods
15,000
15,000
Reverse the deferred profit on the sale of land.
Consolidation Entries—20X3
In 20X3, we use the same approach for the basic consolidation entry computations that we used in 20X1 and 20X2. The Book Value Calculations panel
shows all of Special Foods’ equity accounts on the right side of the panel. On the left side of the calculations panel, we then allocate 80 percent of these
amounts to Peerless and 20 percent of these amounts to NCI. Special Foods’ reported income includes the $10,000 gain it recognized on the sale of land. In
addition to allocating Special Foods’ equity accounts to Peerless and the NCI, we also need to make an adjustment to show that Peerless has reversed in
20X3 the $15,000 gain it deferred in 20X1. This reversal made in entry (15) impacts Peerless’s Investment in Special Foods and Income from Special Foods
accounts beyond those amounts that were allocated from Special Foods’ equity accounts. These adjustments are shown in the Adjustments to Basic Entry
Panel, and the descriptions for the line item amounts to eliminate Income from Special Foods and Investment in Special Foods are labeled as “with
adjustment” in the basic consolidation entry.
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A Key Observation from the calculations for the basic consolidation entry are that the right side of the book value calculations are always based on the
Special Foods’ equity accounts. However, because of the equity method entry (10) that Peerless made in 20X1, Peerless’s 20X3 beginning balance in the
Investment in Subsidiary account is $257,000 and not the $272,000 amount that would be based solely on Special Foods’ equity accounts. The T-accounts
for 20X3 clearly illustrate that even when Peerless makes the 20X3 equity entry (15) to reverse the 20X1 deferral, and then makes the adjustment shown
above to the basic entry, the basic consolidation entry alone will not be sufficient to fully eliminate the Investment in Special Foods account because of this
$15,000 difference. In the year the intercompany transferred asset is sold outside the consolidated company, there is one more consolidation entry that must
be made in addition to the basic consolidation entry to fully eliminate the Investment in Sub account. This entry is discussed and presented next.
In the consolidation worksheet, the land no longer needs to be reduced by the unrealized intercompany gain because the gain now is realized and the
consolidated entity no longer holds the land. Instead, the $10,000 gain recognized by Special Foods on the sale of the land to an outsider must be adjusted to
reflect a total gain for the consolidated entity of $25,000. In addition, the $15,000 difference in the Investment in Special Foods account identified above
must also be adjusted. Thus, the following consolidation entry is made in the consolidation worksheet prepared at the end of 20X3:
Investment in Special Foods
Gain on Sale of Land
15,000
15,000
An examination of Peerless’s Investment in Subsidiary Account shows an ending balance in the same amount of $296,000 at December 31, 20X3, in
three places: (1) in Peerless’s column in the the consolidation worksheet, (2) in Peerless’s T-account, and (3) in the book value calculations for the basic
entry. We can conclude that all differences in this account related to the 20X1 deferral of the unrealized gain, and the 20X3 reversal of this prior deferral,
have now been completely accounted for as of the end of 20X3. There will be no further financial statement impacts of this downstream sale of land in
future years.
The T-accounts below show the balances in Peerless’s accounts on December 31, 20X3. The T-accounts also illustrate how these ending balances are
fully eliminated by the basic consolidation entry and the additional consolidation entry shown above.
The final consolidation entry is to adjust the accumulated depreciation as in previous examples.
page 317
Consolidation Worksheet—20X2
Figure 7–4 presents the 20X3 Consolidation Worksheet prepared on December 31, 20X3. The consolidation entries presented above have been included in
this worksheet.
F I G U R E 7 –4
December 31, 20X3, Consolidation Worksheet, Period of Intercompany Sale; Downstream Sale of Land
Upstream Sale of Land (Year of Sale)
L O 7 –4
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following an upstream land transfer.
Assume an upstream sale of land results in the recording of an intercompany gain on Special Foods’ books. If the gain is unrealized from a consolidated
viewpoint, it must not be included in the consolidated financial statements. Unrealized intercompany gains are eliminated from the consolidation worksheet in
the same manner as in the downstream case. However, the gain consolidation reduces both the controlling and the noncontrolling interests in proportion to
their ownership.
When an upstream asset sale occurs and the parent resells the asset to a nonaffiliate during the same period, all the parent’s equity-method entries and the
consolidation entries in the consolidation worksheet are identical to those in the downstream case. When the asset is not resold to a nonaffiliate before the end
of the period, worksheet consolidation entries are different from the downstream case only by the apportionment of the unrealized intercompany gain to both
the controlling and noncontrolling interests. In this case, because the sale appears on Special Foods’ income statement and because the NCI
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shareholders own 20 percent of Special Foods’ outstanding shares, they are entitled to 20 percent of Special Foods’ net income. Thus, the
deferral of the unrealized gain accrues to both the Peerless and the NCI shareholders. In other words, the intercompany gain on an upstream sale is
recognized by the subsidiary and shared between the controlling and noncontrolling stockholders of the subsidiary. Therefore, the consolidation of the
unrealized intercompany profit must reduce the interests of both ownership groups each period until the profit is realized by resale of the asset to a
nonaffiliated party.
The treatment of an upstream sale may be illustrated with the same example used to illustrate a downstream sale. In this case, Special Foods recognizes a
$15,0002 gain from selling the land to Peerless in addition to the $50,000 of income earned from its regular operations; thus, Special Foods’ net income for
20X1 is $65,000. Peerless’s separate income is $140,000 and comes entirely from its normal operations.
The upstream sale from Special Foods to Peerless is as follows:
Fully Adjusted Equity-Method Entries—20X1
During 20X1, Peerless records the normal entries under the fully adjusted equity method, reflecting its share of Special Foods’ income and dividends:
(16)
Investment in Special Foods
52,000
Income from Special Foods
52,000
Record Peerless’s 80% share of Special Foods’ 20X1 income.
(17)
Cash
24,000
Investment in Special Foods
24,000
Record Peerless’s 80% share of Special Foods’ 20X1 dividend.
These entries are the same as in the illustration of the downstream sale. The only difference is in the fully adjusted equity-method entry to defer the
unrealized gain. The difference is that deferral is only for Peerless’s ownership percentage of Special Foods (80 percent). Thus, the deferral of Peerless’s
relative share of the unrealized gross profit is $12,000 ($15,000 × 0.80).
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(18)
Income from Special Foods
12,000
Investment in Special Foods
Defer Peerless’s 80% share of the unrealized gain on the sale of land to Peerless.
Peerless’s equity-method accounts appear as follows at the end of 20X1:
12,000
In summary, when Peerless defers its 80 percent share of Special Foods’ unrealized gain in the equity-method accounts, the $12,000 decrease in the
Income from Special Foods’ account offsets Peerless’s 80 percent share of the $15,000 gain on Special Foods’ income statement so that Peerless’s income
is correct (and equal to the controlling interest in consolidated net income). Moreover, the $12,000 decrease in the investment account offsets the fact that its
land account is overstated.
Consolidation Worksheet—20X1
Figure 7–5 illustrates the consolidation worksheet prepared at the end of 20X1. The first two consolidation entries are the same as we prepared in Chapter 3
with one minor exception. Although the analysis of the book value portion of the investment account is the same, in preparing the basic consolidation entry,
we reduce the amounts in Peerless’s Income from Special Foods and Investment in Special Foods accounts by Peerless’s share of the gain deferral, $12,000
($15,000 × 0.80). We also reduce the NCI in net income of Special Foods and NCI in net assets of Special Foods by the NCI’s share of the deferral, $3,000
($15,000 × 0.20).
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F I G U R E 7 –5
December 31, 20X1, Consolidation Worksheet, Period of Intercompany Sale; Upstream Sale of Land
The consolidation worksheet entry to correct for the intercompany sale is identical to the downstream case. The only difference is that the unrealized gain
(and overstated income) is now in Special Foods’ column of the consolidation worksheet and the overstated land is now in Peerless’s column.
page 321
Eliminate Gain on Purchase of Land from Special Foods:
Gain on Sale of Land
15,000
Land
15,000
Consolidated Net Income
When intercompany profits that are unrealized from a consolidated point of view are included in a subsidiary’s income, both consolidated net income and the
noncontrolling stockholders’ share of income must be adjusted for the unrealized profits. Consolidated net income for 20X1 is computed and allocated as
follows:
Peerless’s separate income
$140,000
Special Foods’ net income
$65,000
Less: Unrealized intercompany gain on upstream land sale
(15,000)
Special Foods’ realized net income
50,000
Consolidated net income, 20X1
$190,000
Income to noncontrolling interest ($50,000 × 0.20)
(10,000)
Income to controlling interest
$180,000
Consolidated net income in this year is the same whether or not there is an intercompany sale because the gain is unrealized. The unrealized gain must be
eliminated fully, with consolidated net income based only on the realized income of the two affiliates.
Noncontrolling Interest
The income assigned to the noncontrolling shareholders is computed as their proportionate share of the realized income of Special Foods, as follows:
Special Foods’ net income
$65,000
Less: Unrealized intercompany profit on upstream land sale
(15,000)
Special Foods’ realized income
$50,000
Proportionate share to noncontrolling interest
× 0.20
Income to noncontrolling interest
$10,000
The total noncontrolling interest in the net assets of Special Foods is computed, in the absence of a differential, as the noncontrolling stockholders’
proportionate share of the stockholders’ equity of Special Foods, excluding unrealized gains and losses. On December 31, 20X1, the noncontrolling interest
totals $64,000, computed as follows:
Book value of Special Foods, December 31, 20X1:
Common stock
$200,000
Retained earnings
135,000
Total book value
$335,000
Unrealized intercompany gain on upstream land sale
(15,000)
Realized book value of Special Foods
$320,000
Noncontrolling stockholders’ proportionate share
Noncontrolling interest, December 31, 20X1
× 0.20
$ 64,000
Eliminating the Upstream Unrealized Gain after the First Year
As explained previously, in the period in which unrealized profits arise from an intercompany sale, worksheet entries remove the gain or loss recorded by the
seller and adjust the reported amount of the asset back to the price the selling affiliate originally paid. Each period thereafter while the purchasing affiliate
holds the asset, the reported asset balance and the shareholder claims are adjusted to remove the effects of the unrealized gain or loss. Income in those
subsequent periods is not affected. For example, if Peerless continues to hold the land purchased from Special Foods, the unrealized intercompany gain is
eliminated from the reported balance of the land and proportionately from the subsidiary ownership interests with the following entry:
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Investment in Special Foods
12,000
NCI in NA of Special Foods
3,000
Land
15,000
Recall that in the upstream case, Peerless deferred only its 80 percent share of the unrealized gain. As a result, the Investment in Special Foods account is
“artificially low” by $12,000. Thus, it make sense that the consolidation entry can only increase the investment account by the amount that was deferred. All
other consolidation entries are made as if there is no unrealized intercompany gain.
Subsequent Disposition of the Asset
As explained earlier, when previously unrealized intercompany profits are realized, the effects of the profit deferral must be reversed. At the time of
realization, the full amount of the deferred intercompany profit is added back into the consolidated income computation and assigned to the shareholder
interests from which it originally was eliminated. In this example, if Peerless had sold the land to the external party following an upstream intercompany
transfer from Special Foods, the worksheet treatment would be the same as in the case of the downstream transfer except that the debit would be prorated
between investment in Special Foods ($12,000) and NCI in net assets of Special Foods ($3,000) based on the relative ownership interests.
Investment in Special Foods
12,000
NCI in NA of Special Foods
3,000
Gain on Sale of Land
15,000
INTERCOMPANY TRANSFERS OF DEPRECIABLE ASSETS
Unrealized intercompany profits on a depreciable or amortizable asset are viewed as being realized gradually over the remaining economic life of the asset as it
is used by the purchasing affiliate in generating revenue from unaffiliated parties. In effect, a portion of the unrealized gain or loss is realized each period as
benefits are derived from the asset and its service potential expires.
The amount of depreciation recognized on a company’s books each period on an asset purchased from an affiliate is based on the intercompany transfer
price. From a consolidated viewpoint, however, depreciation must be based on the cost of the asset to the consolidated entity, which is the asset’s cost to the
affiliate company that originally purchased it from an outsider. Consolidation entries are needed in the consolidation worksheet to restate the asset, the
associated accumulated depreciation, and the depreciation expense to the amounts that would have appeared in the financial statements if there had been no
intercompany transfer. Because the intercompany sale takes place totally within the consolidated entity, the consolidated financial statements must appear as if
the intercompany transfer had never occurred.
Downstream Sale
L O 7 –5
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following a downstream depreciable asset
transfer.
We now modify the Peerless Products and Special Foods example to illustrate the downstream sale of a depreciable asset. Assume that Peerless sells
equipment to Special Foods on December 31, 20X1, for $7,000, as follows:
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The equipment originally cost Peerless $9,000 when purchased on December 31, 20W8, three years before the December 31, 20X1, sale to Special
Foods. Assume that the equipment has been depreciated based on an estimated useful life of 10 years using the straight-line method with no residual value.
The book value of the equipment immediately before the sale by Peerless is computed as follows:
Original cost to Peerless
$9,000
Accumulated depreciation on December 31, 20X1:
Annual depreciation ($9,000 ÷ 10 years)
$900
Number of years
× 3
(2,700)
Book value on December 31, 20X1
$6,300
The gain recognized by Peerless on the intercompany sale of the equipment is
Sale price of the equipment
$7,000
Less: Book value of the equipment
(6,300)
Gain on sale of the equipment
$
700
Separate-Company Entries—20X1
Special Foods records the purchase of the equipment at its cost:
December 31, 20X1
(19)
Equipment
7,000
Cash
7,000
Record purchase of equipment.
Special Foods does not depreciate the equipment during 20X1 because it purchased the equipment at the very end of 20X1. However, Peerless does record
depreciation expense on the equipment for 20X1 because it holds the asset until the end of the year (and the 20X1 depreciation expense is recorded prior to
calculating the gain on sale shown above):
December 31, 20X1
(20)
Depreciation Expense
900
Accumulated Depreciation
900
Record 20X1 depreciation expense on equipment sold.
Peerless also records the sale of the equipment at the end of 20X1 and recognizes the $700 ($7,000 − $6,300) gain on the sale:
December 31, 20X1
(21)
Cash
7,000
Accumulated Depreciation
2,700
Equipment
9,000
Gain on Sale of Equipment
700
Record sale of equipment.
In addition, Peerless records the normal fully adjusted equity-method entries to recognize its share of Special Foods’ income and dividends for 20X1:
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(22)
Investment in Special Foods Stock
40,000
Income from Special Foods
40,000
Record equity-method income: $50,000 × 0.80.
(23)
Cash
Investment in Special Foods Stock
24,000
24,000
Record dividends from Special Foods: $30,000 × 0.80.
To ensure that its income for 20X1 is correct, under the fully adjusted equity method, Peerless also defers 100 percent of the gain on the downstream
intercompany sale of equipment as follows:
(24)
Income from Special Foods
Investment in Special Foods
700
700
Defer unrealized gain on asset sale to Special Foods.
Thus, Peerless’s equity-method accounts appear as follows at the end of 20X1:
Consolidation Worksheet—20X1
Figure 7–6 illustrates the worksheet to prepare consolidated financial statements at the end of 20X1. To prepare the basic consolidation entry, we first analyze
the book value of Special Foods and allocate each component to Peerless and the NCI shareholders:
The basic consolidation entry is the same as illustrated in Chapter 3 except that we adjust the entries to the Investment in Special Foods and Income from
Special Foods accounts for the gain that has been deferred on the intercompany asset sale ($700):
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F I G U R E 7 –6
December 31, 20X1, Consolidation Worksheet, Period of Intercompany Sale; Downstream
Although Peerless recorded an equity-method entry to defer the unrealized gain on the equipment sale, both the Income from Special Foods and
Investment in Special Foods accounts are eliminated with the basic consolidation entry. Peerless’s income is overstated by the gain ($700). Moreover, Special
Foods’ Buildings and Equipment account is overstated by the same amount. Therefore, we need an additional consolidation entry to remove
page 326
the gain that appears in Peerless’s income statement and to correct the basis of the equipment on Special Foods’ books to make it appear as if
the asset had not been sold within the consolidated group. One way to calculate this consolidation entry is to compare what actually happened (as recorded
on the individual financial statements of the two companies) with how the accounts would have appeared in the consolidated financial statements if the
transfer had not occurred. Whereas the equipment currently resides on Special Foods’ books (valued at the acquisition price of $7,000 with no accumulated
depreciation), we want it to appear in the consolidated financial statements as if it had not been transferred from Peerless to Special Foods (historical cost of
$9,000 with accumulated depreciation of $2,700 as explained previously). The following T-accounts illustrate how to determine the correct consolidation
entry to defer the gain and correct the basis of the asset:
Note that the consolidation entry comprises the adjustments to convert each account from “actual” to “as if ” the transfer had not taken place.
Eliminate Gain on the Equipment Sold to Special Foods and Correct the Asset’s Basis:
Buildings & Equipment
Gain on Sale
2,000
700
Accumulated Depreciation
2,700
Separate-Company Entries—20X2
During 20X2, Special Foods begins depreciating its $7,000 cost of the equipment acquired from Peerless Products over its remaining life of seven years
using straight-line depreciation. The resulting depreciation is $1,000 per year ($7,000 ÷ 7 years):
(25)
Depreciation Expense
1,000
Accumulated Depreciation
1,000
Record depreciation expense for 20X2.
Peerless records its normal equity-method entries for 20X2 to reflect its share of Special Foods’ $74,000 income and dividends of $40,000. Note that
Special Foods’ net income is only $74,000 in 20X2 because it has been reduced by the $1,000 of depreciation on the transferred asset. Accordingly,
Peerless’s share of that income is $59,200 ($74,000 × 0.80).
(26)
Investment in Special Foods
59,200
Income from Subsidiary
59,200
Record equity-method income: $74,000 × 0.80.
(27)
Cash
32,000
Investment in Special Foods
32,000
Record dividends from Special Foods: $40,000 × 0.80.
Peerless must record one additional equity-method entry related to the transferred asset. Because the equipment was recorded at the time of the December
31, 20X1, sale on Special Foods’ balance sheet at $7,000 (rather than the $6,300 book value at which it had been recorded on Peerless’s books), page 327
Special Foods will record “extra” depreciation expense each year over the asset’s seven-year life. Special Foods’ annual depreciation ($7,000 ÷ 7
years = $1,000 per year) is $100 higher per year than it would have been if Peerless had kept the equipment ($900 per year).
Special Foods’ extra depreciation essentially cancels out one-seventh of the unrealized gain. As a result, over the asset’s seven-year life, the unrealized gain is
offset by the $700 of extra depreciation expense. Thus, in 20X2 (and each of the next six years) Peerless adjusts for the extra depreciation by reversing oneseventh of the gain deferral in its equity-method accounts as follows:
(28)
Investment in Special Foods
Income from Special Foods
100
100
Reverse one-seventh of the deferred gain on fixed asset sold to Special Foods.
Consolidation Worksheet—20X2
Figure 7–7 presents the consolidation worksheet for 20X2. The trial balance amounts from the Chapter 3 example have been adjusted to reflect the
intercompany asset sale. To prepare the basic consolidation entry, we again analyze the updated book value of Special Foods and examine the allocation of
each component to Peerless and the NCI shareholders. Thus, to present the consolidated financial statements as if the equipment had not been transferred to
Special Foods, we need to decrease depreciation expense to the amount Peerless would have recorded had the equipment stayed on its books.
page 328
F I G U R E 7 –7
December 31, 20X2, Consolidation Worksheet, Next Period Following Intercompany Sale; Downstream Sale of Equipment
The basic consolidation entry is the same as illustrated in Chapter 3 except that we adjust the entries to the Investment in Special Foods and Income from
Special Foods accounts for the extra $100 of depreciation for 20X2 associated with the asset transfer:
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In the 20X2 worksheet, two consolidation entries are necessary. The first corrects depreciation expense by adjusting it to what it would have been if the
asset had stayed on Peerless’s books. The second revalues the asset from its current book value on Special Foods’ books to what its book value would have
been if it had stayed on Peerless’s books. Again, T-accounts can be a helpful tool in figuring out the consolidation entries. We find it useful to calculate the
consolidation of the extra depreciation expense first because the debit to Accumulated Depreciation affects the calculation of the credit to this account in the
second entry.
The actual amounts in these accounts are based on Special Foods’ acquisition price ($7,000) and its first year’s accumulated depreciation ($1,000). The
“as if” amounts are Peerless’s original cost when it acquired the equipment from an unrelated party and the accumulated depreciation it would have reflected
had the asset stayed on Peerless’s books in the absence of the transfer, $3,600 ($2,700 prior year’s accumulated depreciation + $900 current year’s
depreciation). The second consolidation entry is calculated as the amounts needed to adjust from actual to as if the asset had stayed on Peerless’s books
(after entering the debit to Accumulated Depreciation from the first consolidation entry).
Entries to Adjust Equipment and Accumulated Depreciation as if Still on Parent’s Books:
Accumulated Depreciation
100
Depreciation Expense
100
Investment in Special Foods
Buildings & Equipment
700
2,000
Accumulated Depreciation
2,700
Note that the first consolidation entry backs out the extra depreciation expense from Special Foods’ income statement. Again, the debit to the investment
account in the second consolidation entry is equal to the amount of unrealized gain at the beginning of the year. Given the gain deferral entry in 20X1 under
the fully adjusted equity method, the investment account is artificially low by $700. Thus, the basic consolidation entry would overeliminate this account.
Therefore, the debit of $700 helps to eliminate the investment account. The debit to the Buildings and Equipment account in this consolidation entry is simply
the difference between Special Foods’ cost ($7,000) and Peerless’s historical cost ($9,000). The credit to accumulated depreciation in this consolidation
entry represents the difference between what accumulated depreciation would have been if the asset had stayed on Peerless’s books, $3,600 ($900 × 4
years), and the amount Special Foods actually recorded, $1,000, plus the extra depreciation.
The following T-accounts illustrate how the worksheet entries eliminate the Investment in Special Foods and Income from Special Foods accounts:
page 330
Once all the consolidation entries have been made in the worksheet, the adjusted balances exclude the effects of the intercompany transfer:
Subsidiary Trial Balance
Consolidation
Consolidated Amounts
Buildings & Equipment
$7,000
$2,000
$9,000
Accumulated Depreciation
(1,000)
(2,600)
(3,600)
Depreciation Expense
1,000
(100)
900
Consolidated Net Income and Retained Earnings
Computation of consolidated net income for 20X2 must include an adjustment for the realization of profit on the 20X1 sale of equipment to Special Foods:
Peerless’s separate income
$160,900
Partial realization of intercompany gain on downstream sale of equipment
Peerless’s separate realized income
100
$161,000
Special Foods’ net income
74,000
Consolidated net income, 20X2
$235,000
Income to noncontrolling interest ($74,000 × 0.20)
(14,800)
Income to controlling interest
$220,200
Because Peerless adjusts its investment income from Special Foods for unrealized gains and losses under the fully adjusted equity method, Peerless’s
Retained Earnings account equals the amount that should be reported as consolidated retained earnings. This is one of the advantages of using the fully
adjusted equity method. Appendix 7A illustrates procedures for the modified equity method.
Noncontrolling Interest
Income allocated to the noncontrolling stockholders in 20X2 is equal to their proportionate share of the subsidiary’s realized and reported income. Special
Foods’ net income for 20X2 is $74,000, and the noncontrolling interest’s 20 percent share is $14,800 ($74,000 × 0.20).
The total noncontrolling interest in the net assets of Special Foods at the end of 20X2 is $70,800, equal to the noncontrolling stockholders’ proportionate
share of the total book value of the subsidiary:
Book value of Special Foods, December 31, 20X2:
Common stock
$200,000
Retained earnings
154,000
Total book value
$354,000
Noncontrolling stockholders’ proportionate share
Noncontrolling interest, December 31, 20X2
× 0.20
$ 70,800
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Normally the noncontrolling interest at a particular date is equal to a proportionate share of the subsidiary’s book value plus the noncontrolling interest’s share
of the remaining differential at that date. In this example, however, no differential was recognized at the date of combination.
Consolidation in Subsequent Years
The consolidation procedures in subsequent years are quite similar to those in 20X2. As long as Special Foods continues to hold and depreciate the equipment
(i.e., until the asset is fully depreciated), consolidation procedures include two objectives each year:
1. Restating the asset and accumulated depreciation balances from actual to as if the asset had stayed on Peerless’s books.
2. Adjusting depreciation expense for the year from actual to as if the asset had stayed on Peerless’s books.
Figure 7–8 summarizes the worksheet consolidation entries at December 31 of each year from 20X1 to 20X8. Observation of the consolidation entries
from 20X2–20X8 illustrates a clear pattern. The first consolidation entry to back out the extra depreciation is the same each year. Because the extra
depreciation recorded each year by Special Foods effectively cancels out one-seventh of the unrealized gain and because Peerless continues to record an
equity method adjustment to recognize this canceling of the unrealized gain as shown in entry (21), the debit to the Investment in Special Foods account and
the credit to Accumulated Depreciation in the second consolidation entry each decreases by $100 each year until the asset is fully depreciated and the
intercompany gain is fully recognized. After 20X8, once the transferred asset is fully depreciated, no further equity-method entries are required on Peerless’s
books and only one consolidation entry is required in consolidation related to this asset transfer. The consolidation entry in all subsequent years (for as long
as Special Foods owns the transferred asset) would simply debit Buildings and Equipment for $2,000 (to increase the basis from Special Foods’ acquisition
price of $7,000 to Peerless’s original purchase price of $9,000) and credit Accumulated Depreciation for $2,000.
Change in Estimated Life of Asset upon Transfer
When a depreciable asset is transferred between companies, a change in the remaining estimated economic life may be appropriate. For example, the
acquiring company may use the asset in a different type of production process, or the frequency of use may change. When a change in the estimated life of a
depreciable asset occurs at the time of an intercompany transfer, the treatment is no different than if the change had occurred while the asset remained on the
books of the transferring affiliate. The new remaining useful life is used as a basis for depreciation both by the purchasing affiliate and for purposes of
preparing consolidated financial statements. Thus, the as if calculation assumes the asset stayed on the transferring company’s books but that the transferring
company decided to revise its depreciation estimate to the useful life adopted by the new asset owner.
Upstream Sale
L O 7 –6
Prepare equity-method journal entries and consolidation entries for the consolidation of a subsidiary following an upstream depreciable asset
transfer.
The treatment of unrealized profits arising from upstream intercompany sales is identical to that of downstream sales except that the unrealized profit, and
subsequent realization, must be allocated between the controlling and noncontrolling interests. We illustrate an upstream sale using the same example we
demonstrated previously for the downstream sale. Assume that Special Foods sells equipment to Peerless Products for $7,000 on December 31, 20X1, and
reports total income for 20X1 of $50,700 ($50,000 + $700), including the $700 gain on the sale of the equipment. Special Foods originally purchased the
equipment for $9,000 three years before the intercompany sale. 3
page 332
F I G U R E 7 –8
Summary of Worksheet Consolidation Entries over the Life of the Transferred Asset (Downstream Transfer)
page 333
The book value of the equipment at the date of sale is as follows:
Original cost to Special Foods
$9,000
Accumulated depreciation on December 31, 20X1:
Annual depreciation ($9,000 ÷ 10 years)
Number of years
$900
×
3
(2,700)
Book value on December 31, 20X1
$6,300
Separate-Company Entries—20X1
Special Foods records depreciation on the equipment for the year and the sale of the equipment to Peerless on December 31, 20X1, with the following
entries:
December 31, 20X1
(29)
Depreciation Expense
900
Accumulated Depreciation
900
Record 20X1 depreciation expense on equipment sold.
December 31, 20X1
(30)
Cash
7,000
Accumulated Depreciation
2,700
Equipment
9,000
Gain on Sale of Equipment
700
Record sale of equipment.
Peerless records the purchase of the equipment from Special Foods with the following entry:
December 31, 20X1
(31)
Equipment
7,000
Cash
7,000
Record purchase of equipment.
In addition, Peerless records the following equity-method entries on December 31, 20X1, to recognize its share of Special Foods’ reported income and
dividends:
(32)
Investment in Special Foods
Income from Special Foods
Record Peerless’s 80% share of Special Foods’ 20X1 income: $50,700 × 0.80.
40,560
40,560
(33)
Cash
24,000
Investment in Special Foods
24,000
Record Peerless’s 80% share of Special Foods’ 20X1 dividend: $30,000 × 0.80.
Finally, under the fully adjusted equity method, Peerless records its share of the gain deferral from the purchase of the equipment from Special Foods:
(34)
Income from Special Foods
560
Investment in Special Foods
560
Defer 80% of the unrealized gain on equipment purchase from Special Foods: $700 × 0.80.
These entries result in the following balances in the Investment in Special Foods and Income from Special Foods equity-method accounts:
page 334
Consolidation Worksheet—20X1
Figure 7–9 illustrates the consolidation worksheet for 20X1. It is the same as the worksheet presented in Figure 7–5 except for minor modifications to reflect
the upstream sale of the equipment. As usual, to prepare the basic consolidation entry, we first analyze the book value of Special Foods and allocate each
component to Peerless and the NCI shareholders:
The basic consolidation entry is the same as illustrated in Chapter 3 except that we adjust both the controlling and noncontrolling interests in Special Foods’
income and net assets by their respective shares of the gain that has been deferred on the intercompany asset sale:
As illustrated previously, one way to calculate the gain consolidation entry is to compare what actually happened (as recorded on the individual financial
statements of the two companies) with how the transaction would appear in the consolidated financial statements if the asset transfer had not taken place.
Whereas the equipment currently resides on Peerless’s books (valued at the acquisition price of $7,000 with no accumulated depreciation), we
page 335
want it to appear in the consolidated financial statements as if it had not been transferred from Special Foods to Peerless (historical cost of
$9,000 with accumulated depreciation of $2,700, as explained previously). The following T-accounts illustrate how to determine the correct consolidation
entry to defer the gain and correct the basis of the asset:
Eliminate Gain on the Equipment Sold to Special Foods and Correct the Asset’s Basis:
Gain on Sale
700
Buildings & Equipment
2,000
Accumulated Depreciation
2,700
As it turns out, the consolidation entry for the upstream sale is exactly the same as the downstream example for 20X1.
As illustrated in Figure 7–9, the income assigned to the noncontrolling shareholders based on their share of Special Foods’ realized income is computed as
follows:
Net income of Special Foods for 20X1
Unrealized gain on intercompany sale
Realized net income of Special Foods for 20X1
Noncontrolling stockholders’ proportionate share
Income to noncontrolling interest, 20X1
$50,700
(700)
$50,000
×0.20
$10,000
In the upstream case, as in the downstream case, consolidated net income is reduced by the amount of the current period’s unrealized gain on the
intercompany transfer. However, in the upstream case, the unrealized gain reduces both the controlling and noncontrolling interests proportionately because
both are owners of Special Foods and share in the gain. The allocation of Special Foods’ income to the controlling and noncontrolling interests is based on
Special Foods’ realized net income after having deducted the unrealized gain. The computation and allocation of 20X1 consolidated net income is as follows:
Peerless’s separate income
Special Foods’ net income
Less: Unrealized intercompany gain on upstream sale of equipment
Special Foods’ realized net income
$140,000
$50,700
(700)
50,000
Consolidated net income, 20X1
$190,000
Income to noncontrolling interest ($50,000 × 0.20)
(10,000)
Income to controlling interest
$180,000
Separate-Company Books—20X2
In the year following the intercompany transfer, Special Foods reports net income of $75,900 (because the $900 of depreciation expense on the transferred
asset is now on Peerless’s income statement). In the upstream example, the extra $100 of depreciation expense now appears in Peerless’s income page 336
statement:
F I G U R E 7 –9
December 31, 20X1, Consolidation Worksheet, Period of Intercompany Sale; Upstream Sale of Equipment
Peerless records the normal fully adjusted equity-method entries on its books to recognize its share of Special Foods’ 20X2 income and dividends. Moreover,
it recognizes 80 percent of the deferred gain, $80 (($700 ÷ 7 years) × 0.80).
Peerless’s extra depreciation essentially cancels out one-seventh of the unrealized gain. As a result, over the seven-year life of the asset, Peerless
recognizes one-seventh of the gain deferral each year in its equity-method accounts:
page 337
(35)
Investment in Special Foods
Income from Special Foods
Recognize 80% of 1/7 of the deferred gain on fixed asset purchased from Special Foods.
At the end of 20X2, the Investment in Special Foods and Income from Special Foods accounts on Peerless’s books appear as follows:
80
80
Consolidation Entries—20X2
Figure 7–10 presents the consolidation worksheet for 20X2. We again analyze the updated book value of Special Foods and examine the allocation of each
component to Peerless and the NCI shareholders. Also, to present the consolidated financial statements as if the equipment had not been transferred to
Peerless, we need to decrease depreciation expense to the amount Special Foods would have recorded had the equipment stayed on its books.
The basic consolidation entry is the same as illustrated in Chapter 3 except that we adjust the entries to the Investment in Special Foods and Income from
Special Foods accounts for their 80 percent share of the extra $100 of depreciation for 20X2 associated with the asset transfer. Moreover, we add back 20
percent of the $100 of extra depreciation to the NCI in NI of Special Foods and NCI in NA of Special Foods:
page 338
F I G U R E 7 –1 0
December 31, 20X2, Consolidation Worksheet, Next Period Following Intercompany Sale; Upstream Sale of Equipment
In the 20X2 worksheet, the same two consolidation entries discussed in the downstream example are necessary. The only difference from the
downstream example is that the amount of deferred gain on Special Foods’ equipment sale to Peerless at the beginning of the period ($700) is
page 339
allocated between Peerless and the NCI shareholders based on their relative ownership percentages. Again, T-accounts can be a helpful tool in
figuring out the consolidation entries. It is helpful to calculate the consolidation of the extra depreciation expense first because the debit to Accumulated
Depreciation affects the calculation of the credit to this account in the second entry.
Accumulated Depreciation
100
Depreciation Expense
100
The actual amounts in these accounts are based on Peerless’s acquisition price ($7,000) and its first year’s accumulated depreciation ($1,000). The as if
amounts are Special Foods’ original cost when it acquired the equipment from an unrelated party and the accumulated depreciation it would have reflected
had the asset stayed on Special Foods’ books in the absence of the transfer, $3,600 ($2,700 prior-year accumulated depreciation + $900 current-year
depreciation). The second consolidation entry is calculated as the amounts needed to adjust from actual to as if the asset had stayed on Special Foods’ books.
Entries to Adjust Equipment and Accumulated Depreciation as if Still on Subsidiary’s Books:
Investment in Special Foods
560
NCI in NA of Special Foods
140
Buildings & Equipment
2,000
Accumulated Depreciation
2,700
As explained in the downstream example, the key to understanding these consolidation entries is that the debit to the investment account in the first
consolidation entry is equal to Peerless’s share of the unrealized gain at the beginning of the year. Given the gain deferral entry in 20X1 under the fully
adjusted equity method, the investment account is artificially low by $560. Thus, the basic consolidation entry would overeliminate this account. For this
reason, the debit of $560 helps to eliminate the investment account. The rest of the deferral, $140, is allocated to the noncontrolling interest.
Consolidated Net Income
Peerless Products’ separate income for 20X2 is $159,000 after deducting an additional $1,000 for the depreciation on the transferred asset. Consolidated net
income for 20X2 is computed and allocated as follows:
Peerless’s separate income
$159,000
Special Foods’ net income
$75,900
Partial realization of intercompany gain on upstream sale of equipment
Special Foods’ realized net income
100
76,000
Consolidated net income, 20X2
$235,000
Income to noncontrolling interest ($76,000 × 0.20)
(15,200)
Income to controlling interest
$219,800
Note that the partial realization of intercompany gain on the asset transfer is the extra depreciation recorded this year by Peerless.
page 340
Noncontrolling Interest
The noncontrolling interest’s share of income is $15,200 for 20X2, computed as the noncontrolling stockholders’ proportionate share of the realized income
of Special Foods ($76,000 × 0.20). Total noncontrolling interest in the absence of a differential is computed as the noncontrolling stockholders’ proportionate
share of the stockholders’ equity of Special Foods, excluding unrealized gains and losses. On December 31, 20X2, the noncontrolling interest totals $71,200,
computed as follows:
Book value of Special Foods, December 31, 20X2:
Common Stock
Retained earnings ($120,700 + $75,900 − $40,000)
Total book value
Unrealized 20X1 intercompany gain on upstream sale
Intercompany gain realized in 20X2
Realized book value of Special Foods
$200,000
156,600
$356,600
(700)
100
$356,000
Noncontrolling stockholders’ share
Noncontrolling interest, December 31, 20X2
×
0.20
$ 71,200
Consolidation in Subsequent Years
The consolidation procedures in subsequent years are quite similar to those in 20X2. Figure 7–11 summarizes the worksheet consolidation entries at
December 31 of each year from 20X2 to 20X8. We omit 20X1 because it is identical to the downstream entry reported in Figure 7–8. Observation of the
consolidation entries from 20X2–20X8 again illustrates a clear pattern. The first consolidation entry to back out the extra depreciation is the same each year.
Because the extra depreciation recorded each year by Peerless effectively cancels out one-seventh of the unrealized gain and because Peerless continues to
record an equity-method adjustment to recognize this acknowledgment of the unrealized gain (entry 28), the sum of the debits to the Investment and NCI in
NA of Special Foods accounts, and the credit to Accumulated Depreciation in the second consolidation entry, each decreases by $100 each year until the
asset is fully depreciated and the intercompany gain is fully recognized. After 20X8, no further equity-method entries are required on Peerless’s books, and
only one consolidation entry is required in consolidation related to this asset transfer. The consolidation entry in all subsequent years (for as long as Peerless
owns the transferred asset) would simply debit Buildings and Equipment for $2,000 (to increase the basis from Peerless’s acquisition price of $7,000 to
Special Foods’ original purchase price of $9,000) and credit Accumulated Depreciation for $2,000.
Asset Transfers before Year-End
In cases in which an intercompany asset transfer occurs during a period rather than at its end, a portion of the intercompany gain or loss is considered to be
realized in the period of the transfer. When this occurs, the worksheet consolidation entries at year-end must include an adjustment of depreciation expense
and accumulated depreciation. The amount of this adjustment is equal to the difference between the depreciation recorded by the purchaser and that which
would have been recorded by the seller during the portion of the year elapsing after the intercompany sale.
For example, if the upstream equipment sale from Special Foods to Peerless had occurred on January 1, 20X1, rather than on December 31, 20X1, an
additional consolidation entry (the second entry listed for every other year) would be needed in the consolidation worksheet on December 31, 20X1, to
eliminate the extra depreciation.
page 341
F I G U R E 7 –1 1
Summary of Worksheet Consolidation Entries over the Life of the Transferred Asset (Upstream Transfer)
page 342
INTERCOMPANY TRANSFERS OF AMORTIZABLE ASSETS
Production rights, patents, and other types of intangible assets may be sold to affiliated enterprises. Accounting for intangible assets usually differs from
accounting for tangible assets in that amortizable intangibles normally are reported at the remaining unamortized balance without the use of a contra account
for accumulated amortization. Other than netting the accumulated amortization on an intangible asset against the asset cost, the intercompany sale of
intangibles is treated in the same way in consolidation as the intercompany sale of tangible assets.
SUMMARY OF KEY CONCEPTS
Transactions between affiliated companies within a consolidated entity must be viewed as if they occurred within a single company. Under generally accepted
accounting principles, the effects of transactions that are internal to an enterprise may not be included in external accounting reports. Therefore, the effects of all
transactions between companies within the consolidated entity must be eliminated in preparing consolidated financial statements.
The treatment of intercompany noncurrent asset transfers is similar to the treatment of intercompany inventory transfers discussed in Chapter 6. The
consolidation of intercompany transactions must include the removal of unrealized intercompany profits. When one company sells an asset to an affiliate within the
consolidated entity, any intercompany profit is not considered realized until confirmed by subsequent events. If the asset has an unlimited life, as with land, the
unrealized intercompany gain or loss is realized at the time the asset is resold to a party outside the consolidated entity. If the asset has a limited life, the unrealized
intercompany gain or loss is considered to be realized over the remaining life of the asset as the asset is used and depreciated or amortized.
Consolidation procedures relating to unrealized gains and losses on intercompany transfers of assets involve worksheet adjustments to restate the assets and
associated accounts, such as accumulated depreciation, to the balances that would be reported if there had been no intercompany transfer. In the period of transfer,
the income assigned to the shareholders of the selling affiliate must be reduced by their share of the unrealized intercompany profit. If the sale is a downstream sale,
the unrealized intercompany gain or loss is eliminated against the controlling interest. When an upstream sale occurs, the unrealized intercompany gain or loss is
eliminated proportionately against the controlling and noncontrolling interests.
KEY TERMS
downstream sale, 303
upstream sale, 303
Appendix 7A
Intercompany Noncurrent Asset
Transactions—Modified Equity Method
and Cost Method
A parent company may account for a subsidiary using any of several methods. So long as the subsidiary is to be consolidated, the method of accounting for it on
the parent’s books will have no impact on the consolidated financial statements. Although the primary focus of this chapter is on consolidation using the fully
adjusted equity method on the parent’s books, two other methods are used in practice with some frequency as well. These methods are the modified equity method
and the cost method.
MODIFIED EQUITY METHOD
A company that chooses to account for an investment using the modified equity method records its proportionate share of subsidiary income and dividends in the
same manner as under the fully adjusted equity method. However, it does not defer its share of any unrealized profits from intercompany transactions page 343
using equity-method entries. Instead, these unrealized gains and losses are removed from the parent’s retained earnings in the period after the
intercompany sale. In the absence of these equity-method adjustments, the parent’s net income is usually not equal to the amount of consolidated net income
allocated to the controlling interest.
As an illustration, assume the same facts as in the upstream sale of equipment discussed previously and reflected in the worksheets presented in Figures 7–9
and 7–10. Special Foods sells equipment to Peerless Products for $7,000 on December 31, 20X1, and reports total income of $50,700 for 20X1, including the $700 gain
on the sale of the equipment. Special Foods originally purchased the equipment for $9,000 three years before the intercompany sale. Both companies use straightline depreciation.
As illustrated previously, Special Foods records 20X1 depreciation on the equipment and the gain on the December 31, 20X1, sale of the equipment to Peerless
with the following entries:
December 31, 20X1
(36)
Depreciation Expense
Accumulated Depreciation
Record 20X1 depreciation expense on equipment sold.
900
900
December 31, 20X1
(37)
Cash
7,000
Accumulated Depreciation
2,700
Equipment
9,000
Gain on Sale of Equipment
700
Record sale of equipment.
Peerless records the purchase of the equipment from Special Foods with the following entry:
December 31, 20X1
(38)
Equipment
7,000
Cash
7,000
Record purchase of equipment.
Modified Equity-Method Entries—20X1
In addition, Peerless records the following modified equity-method entries on December 31, 20X1, to recognize its share of Special Foods’ reported income and
dividends:
(39)
Investment in Special Foods
40,560
Income from Special Foods
40,560
Record Peerless’s 80% share of Special Foods’ 20X1 income: $50,700 × 0.80.
(40)
Cash
24,000
Investment in Special Foods
24,000
Record Peerless’s 80% share of Special Foods’ 20X1 dividend: $30,000 × 0.80.
However, Peerless does not record an equity-method entry for its share of the gain deferral from the purchase of the asset from Special Foods.
Consolidation Entries—20X1
The consolidation worksheet consolidation entries under the modified equity method are almost identical to those used under the fully adjusted equity method for
20X1 with one minor exception. We go through the exact same analysis of the book value of Special Foods and allocate each component to Peerless and the NCI
shareholders:
page 344
The basic consolidation entry under the modified equity method is almost identical to the basic consolidation entry under the fully adjusted equity method with one
minor exception. Because we don’t make equity-method adjustments for the unrealized gain in Peerless’s books, we no longer adjust the entries to the Investment in
Special Foods and Income from Special Foods accounts for the gain that has been deferred on the intercompany asset sale. Note that we continue to adjust the NCI
shareholders’ share of Special Foods’ income and their share of Special Foods’ book value of net assets:
The following T-accounts illustrate that we arrive at the exact same answer in 20X1 for eliminating the intercompany gain on the sale of equipment from Special
Foods to Peerless Products:
Eliminate Gain on the Equipment Sold to Special Foods and Correct the Asset’s Basis:
Gain on Sale
Buildings & Equipment
Accumulated Depreciation
700
2,000
2,700
page 345
Figure 7–12 illustrates the consolidation worksheet for 20X1.
Modified Equity-Method Entries—20X2
In 20X2, Peerless records its share of Special Foods’ $75,900 income and $40,000 of dividends as follows:
(41)
Investment in Special Foods
60,720
Income from Special Foods
60,720
Record Peerless’s 80% share of Special Foods’ 20X2 income: $75,900 × 0.80.
(42)
Cash
32,000
Investment in Special Foods
32,000
Record Peerless’s 80% share of Special Foods’ 20X2 dividend: $40,000 × 0.80.
Peerless does not make an entry under the modified equity method to increase income for the partial realization of the unrealized intercompany gain.
Consolidation Entries—20X2
To derive the consolidation entries for the 20X2 worksheet, we again analyze the updated book value of Special Foods and examine the allocation of each
component to Peerless and the NCI shareholders. Also, to present the consolidated financial statements as if the equipment had not been transferred to Peerless,
we need to decrease depreciation expense to the amount Special Foods would have recorded had the equipment stayed on its books.
F I G U R E 7 –1 2
December 31, 20X1, Modified Equity Method Consolidation Worksheet, Period of Intercompany Sale; Upstream Sale of Equipment
page 346
The basic consolidation entry is the same as illustrated for the fully adjusted equity method except that we no longer adjust the entries to the Investment in Special
Foods and Income from Special Foods accounts for their 80 percent share of the extra $100 of depreciation for 20X2 associated with the asset transfer. However, we
continue to add back 20 percent of the $100 of extra depreciation to the NCI in NI of Special Foods and NCI in NA of Special Foods:
In the 20X2 worksheet, the only difference from the fully adjusted equity-method example is that although the amount of deferred gain on Special Foods’
equipment sale to Peerless at the beginning of the period ($700) is still allocated between Peerless and the NCI shareholders based on their relative ownership
percentages, the amount accruing to Peerless is recorded as a decrease to beginning Retained Earnings rather than as a debit to the Investment in Special Foods
account. The reason the consolidation entry affects the Retained Earnings account instead of the Investment in Special Foods account is that no adjustments have
been made under the equity method to ensure that Peerless’s books are up-to-date. T-accounts can be a helpful tool in figuring out the consolidation entries:
page 347
Accumulated Depreciation
Depreciation Expense
100
100
Entries to Adjust Equipment and Accumulated Depreciation as if Still on Parent’s Books:
Retained Earnings
560
NCI in NA of Special Foods
140
Buildings & Equipment
Accumulated Depreciation
2,000
2,700
Again, these consolidation entries related to the intercompany asset sale are identical to those used under the fully adjusted equity method with the one
exception that the debit for $560 in the second consolidation entry goes to Retained Earnings rather than the Investment in Special Foods account. In all cases, the
entries under the modified equity method are identical to those illustrated in Figure 7–9 except that the entries to the Investment in Special Foods account are
replaced with entries to Retained Earnings.
Figure 7–13 illustrates the consolidation worksheet for 20X2.
F I G U R E 7 –1 3
December 31, 20X2, Modified Equity-Method Consolidation Worksheet, Next Period Following Intercompany Sale; Upstream Sale of
Equipment
page 348
COST METHOD
When using the cost method of accounting for an investment in a subsidiary, the parent records dividends received from the subsidiary during the period as
income. No entries are made under the cost method to record the parent’s share of undistributed subsidiary earnings, amortize differential, or remove unrealized
intercompany profits.
To illustrate consolidation following an intercompany sale of equipment when the parent accounts for its subsidiary investment using the cost method, assume
the same facts as in the previous illustrations of an upstream sale.
Consolidation Entries—20X1
The following consolidation entries would appear in the worksheet used to consolidate Peerless and Special Foods at the end of 20X1, assuming Peerless uses the
cost method to account for its investment:
Investment Consolidation Entry:
Common Stock
Retained Earnings
Investment in Special Foods
NCI in NA of Special Foods
200,000
100,000
240,000
60,000
Dividend Consolidation Entry:
Dividend Income
NCI in NI of Special Foods
Dividends Declared
24,000
6,000
30,000
The amount of undistributed net income assigned to the NCI is adjusted for the NCI’s share of the gain deferral.
NCI in NI and NCI in NA of Special Foods:
NCI 20%
Net Income
10,140
+ Dividend
(6,000)
− Gain on Equipment Deferral
(140)
NCI in NI of Special Foods
4,000
Eliminate Asset Purchase from Special Foods:
Buildings & Equipment
Gain on Sale
Accumulated Depreciation
2,000
700
2,700
The first four consolidation entries are identical to those illustrated in Appendix 6A. They (1) eliminate the book value of Special Foods’ equity accounts against the
original investment account, (2) eliminate Special Foods’ 20X1 dividends declared, (3) assign undistributed realized income to the NCI shareholders, and page 349
(4) eliminate accumulated depreciation recorded by Special Foods on fixed assets prior to Peerless’s acquisition. Finally, the consolidation entry related
to the fixed asset transfer is identical to the one used under both the fully adjusted and modified equity methods.
Figure 7–14 illustrates the consolidation worksheet for 20X1.
F I G U R E 7 –1 4
December 31, 20X1, Cost Method Consolidation Worksheet, Period of Intercompany Sale; Upstream Sale of Equipment
Consolidation Entries—20X2
The following consolidation entries would appear in the worksheet used to consolidate Peerless and Special Foods at the end of 20X2, assuming Peerless uses the
cost method to account for its investment:
Investment Consolidation Entry:
Common Stock
Retained Earnings
Investment in Special Foods
200,000
100,000
240,000
NCI in NA of Special Foods
60,000
page 350
Dividend Consolidation Entry:
Dividend Income
NCI in NI of Special Foods
32,000
8,000
Dividends Declared
40,000
NCI in NI and NCI in NA of Special Foods:
NCI 20%
Net Income
15,180
− Dividend
(8,000)
+ Reverse GP Deferral
20
NCI in NI of Special Foods
7,200
Undistributed from Prior Years
4,140
NCI in NA of Special Foods
11,340
Entries to Adjust Equipment and Accumulated Depreciation as if Still on Subsidiary’s Books:
Accumulated Depreciation
100
Depreciation Expense
100
Retained Earnings †
560
NCI in NA of Special Foods
140
Buildings & Equipment
Accumulated Depreciation
2,000
2,700
Again, the first four consolidation entries are essentially identical to those illustrated in Appendix 6A. They (1) eliminate the book value of Special Foods’ equity
accounts against the original investment account, (2) eliminate Special Foods’ 20X1 dividends declared, (3) assign undistributed income to the NCI shareholders,
and (4) eliminate accumulated depreciation recorded by Special Foods on fixed assets prior to Peerless’s acquisition. Finally, the consolidation entries related to the
fixed asset transfer is identical to the one used under the modified equity method.
Figure 7–15 illustrates the consolidation worksheet for 20X2.
page 351
F I G U R E 7 –1 5
December 31, 20X2, Cost Method Consolidation Worksheet, Next Period Following Intercompany Sale; Upstream Sale of Equipment
QUESTIONS
Q7–1
When are profits on intercompany sales considered to be realized? Explain.
LO 7–1
Q7–2
What is an upstream sale? Which company may have unrealized profits on its books in an
upstream sale?
LO 7–2
Q7–3
What dollar amounts in the consolidated financial statements will be incorrect if intercompany
services are not eliminated?
LO 7–1
Q7–4
How are unrealized profits on current-period intercompany sales treated in preparing the income
statement for (a) the selling company and (b) the consolidated entity?
LO 7–1
Q7–5
How are unrealized profits treated in the consolidated income statement if the intercompany sale
occurred in a prior period and the transferred item is sold to a nonaffiliate in the current period?
LO 7–1
page 352
Q7–6
How are unrealized intercompany profits treated in the consolidated statements if the
intercompany sale occurred in a prior period and the profits have not been realized by the end of
the current period?
LO 7–1
Q7–7
What is a downstream sale? Which company may have unrealized profits on its books in a
downstream sale?
LO 7–2
Q7–8
What portion of the unrealized intercompany profit is eliminated in a downstream sale? In an
upstream sale?
LO 7–2, 7–3, 7–4
Q7–9
How is the effect of unrealized intercompany profits on consolidated net income different
between an upstream and a downstream sale?
LO 7–2
Q7–10
Unrealized profits from a prior-year upstream sale were realized in the current period. What
effect will this event have on income assigned to the noncontrolling interest in the consolidated
income statement for the current period?
LO 7–4
Q7–11
A subsidiary sold a depreciable asset to the parent company at a gain in the current period. Will
the income assigned to the noncontrolling interest in the consolidated income statement for the
current period be more than, less than, or equal to a proportionate share of the reported net
income of the subsidiary? Why?
LO 7–6
Q7–12
A subsidiary sold a depreciable asset to the parent company at a profit of $1,000 in the current
period. Will the income assigned to the noncontrolling interest in the consolidated income
statement for the current period be more if the intercompany sale occurs on January 1 or on
December 31? Why?
LO 7–6
Q7–13
If a company sells a depreciable asset to its subsidiary at a profit on December 31, 20X3, what
account balances must be eliminated or adjusted in preparing the consolidated income statement
for 20X3?
LO 7–5
Q7–14
If the sale in the preceding question occurs on January 1, 20X3, what additional account will
require adjustment in preparing the consolidated income statement?
LO 7–5
Q7–15
In the period in which an intercompany sale occurs, how do the consolidation entries differ
when unrealized profits pertain to an intangible asset rather than a tangible asset?
LO 7–5, 7–6
Q7–16
When is unrealized profit on an intercompany sale of land considered realized? When is profit
on an intercompany sale of equipment considered realized? Why do the treatments differ?
LO 7–3
Q7–17
In the consolidation of a prior-period unrealized intercompany gain on depreciable assets, why
does the debit to the Investment account decrease over time?
LO 7–5, 7–6
Q7–18A
A parent company may use on its books one of several different methods of accounting for its
ownership of a subsidiary: (a) cost method, (b) modified equity method, or (c) fully adjusted
equity method. How will the choice of method affect the reported balance in the investment
account when there are unrealized intercompany profits on the parent’s books at the end of the
period?
LO 7–2, 7–5, 7–6
CASES
C7–1
Correction of Consolidation Procedures
LO 7–6
Research
Plug Corporation purchased 60 percent of Coy Company’s common stock approximately 10 years ago. On January 1, 20X2, Coy sold equipment to Plug for $850,000
and recorded a $150,000 loss on the sale. Coy had purchased the equipment for $1,200,000 on January 1, 20X0, and was depreciating it on a straight-line basis over
12 years with no assumed residual value.
In preparing Plug’s consolidated financial statements for 20X2, its chief accountant increased the reported amount of the equipment by $150,000 and eliminated
the loss on the sale of equipment recorded by Coy. No other consolidations or adjustments related to the equipment were made.
Required
As a member of the audit firm Gotcha and Gotcha, you have been asked, after reviewing Plug’s consolidated income statement, to prepare a memo to Plug’s
controller detailing the consolidation procedures that should be followed in transferring equipment between subsidiary and parent. Include citations to or
quotations from the authoritative literature to support your recommendations. Your memo should include the correct consolidation entry and explain why each debit
and credit is needed.
“A” indicates that the item relates to Appendix 7A.
page 353
C7–2
Consolidation of Intercompany Services
LO 7–1, 7–2
Research
Dream Corporation owns 90 percent of Classic Company’s common stock and 70 percent of Plain Company’s stock. Dream provides legal services to each
subsidiary and bills it for 150 percent of the cost of the services provided. During 20X3, Classic recorded legal expenses of $80,000 when it paid Dream for legal
assistance in an unsuccessful patent infringement suit against another company, and Plain recorded legal expenses of $150,000 when it paid Dream for legal work
associated with the purchase of additional property in Montana to expand an existing strip mine owned by Plain. In preparing the consolidated statements at
December 31, 20X3, no consolidation entries were made for intercompany services. When asked why no entries had been made to eliminate the intercompany
services, Dream’s chief accountant replied that intercompany services are not mentioned in the company accounting manual and can be ignored.
Required
Prepare a memo detailing the appropriate treatment of legal services provided by Dream to Plain and Classic during 20X3. Include citations to or quotations from
authoritative accounting standards to support your recommendations. In addition, provide the consolidation entries at December 31, 20X3 and 20X4, needed as a
result of the services provided in 20X3, and explain why each debit or credit is necessary.
C7–3
Noncontrolling Interest
LO 7–2, 7–5
Understanding
Current reporting standards require the consolidated entity to include all the revenues, expenses, assets, and liabilities of the parent and its subsidiaries in the
consolidated financial statements. When the parent does not own all of a subsidiary’s shares, various rules and procedures exist with regard to the assignment of
income and net assets to noncontrolling shareholders and the way in which the noncontrolling interest is to be reported.
Required
a.
How is the amount of income assigned to noncontrolling shareholders in the consolidated income statement computed if there are no unrealized intercompany
profits on the subsidiary’s books?
b.
How is the amount reported for the noncontrolling interest in the consolidated balance sheet computed if there are no unrealized intercompany profits on the
subsidiary’s books?
c.
What effect do unrealized intercompany profits have on the computation of income assigned to the noncontrolling interest if the profits arose from a transfer of
(1) land or (2) equipment?
d.
Are the noncontrolling shareholders of a subsidiary likely to find the amounts assigned to them in the consolidated financial statements useful? Explain.
C7–4
Intercompany Sale of Services
LO 7–1, 7–4
Analysis
Diamond Manufacturing Company regularly purchases janitorial and maintenance services from its wholly owned subsidiary, Schwartz Maintenance Services Inc.
Schwartz bills Diamond monthly at its regular rates for the services provided, with the services consisting primarily of cleaning, grounds keeping, and small repairs.
The cost of providing the services that Schwartz sells consists mostly of salaries and associated labor costs that total about 60 percent of the amount billed.
Diamond issues consolidated financial statements annually.
Required
a.
When Diamond prepares consolidated financial statements, what account balances of Diamond and Schwartz related to the intercompany sale of services must be
adjusted or eliminated in the consolidation worksheet? What impact do these adjustments have on consolidated net income?
b.
In the case of intercompany sales of services at a profit, at what point in time are the intercompany profits considered to be realized? Explain.
C7–5
Intercompany Profits
LO 7–1
Analysis
Companies have many different practices for pricing transfers of goods and services from one affiliate to another. Regardless of the approaches used for internal
decision making and performance evaluation or for tax purposes, all intercompany profits, unless immaterial, are supposed to be eliminated when preparing
consolidated financial statements until confirmed through transactions with external parties.
Required
Verizon Communications is in the telephone business, although it is larger and more diversified than many smaller telecommunications companies. How does it treat
intercompany profits for consolidation?
page 354
EXERCISES
E7–1
Multiple-Choice Questions on Intercompany Transfers [AICPA Adapted]
LO 7–5, 7–6
For each question, select the single best answer.
1. Water Company owns 80 percent of Fire Company’s outstanding common stock. On December 31, 20X9, Fire sold equipment to Water at a price in excess of
Fire’s carrying amount but less than its original cost. On a consolidated balance sheet at December 31, 20X9, the carrying amount of the equipment should be
reported at
a. Water’s original cost.
b. Fire’s original cost.
c. Water’s original cost less Fire’s recorded gain.
d. Water’s original cost less 80 percent of Fire’s recorded gain.
2. Company J acquired all of Company K’s outstanding common stock in exchange for cash. The acquisition price exceeds the fair value of net assets acquired.
How should Company J determine the amounts to be reported for the plant and equipment and long-term debt acquired from Company K?
Plant and Equipment
Long-Term Debt
a. K’s carrying amount
K’s carrying amount
b. K’s carrying amount
Fair value
c. Fair value
K’s carrying amount
d. Fair value
Fair value
3. Port Inc. owns 100 percent of Salem Inc. On January 1, 20X2, Port sold delivery equipment to Salem at a gain. Port had owned the equipment for two years and
used a five-year straight-line depreciation rate with no residual value. Salem is using a three-year straight-line depreciation rate with no residual value for the
equipment. In the consolidated income statement, Salem’s recorded depreciation expense on the equipment for 20X2 will be decreased by
a. 20 percent of the gain on the sale.
b. 33⅓ percent of the gain on the sale.
c. 50 percent of the gain on the sale.
d. 100 percent of the gain on the sale.
4. On January 1, 20X0, Poe Corporation sold a machine for $900,000 to Saxe Corporation, its wholly owned subsidiary. Poe paid $1,100,000 for this machine, which
had accumulated depreciation of $250,000. Poe estimated a $100,000 salvage value and depreciated the machine using the straight-line method over 20 years, a
policy that Saxe continued. In Poe’s December 31, 20X0, consolidated balance sheet, this machine should be included in fixed-asset cost and accumulated
depreciation as
Cost
Accumulated Depreciation
a. $1,100,000
$ 300,000
b. $1,100,000
$ 290,000
c. $
900,000
$
40,000
d. $
850,000
$
42,500
5. Scroll Inc., a wholly owned subsidiary of Pirn Inc., began operations on January 1, 20X1. The following information is from the condensed 20X1 income
statements of Pirn and Scroll:
Pirn
Scroll
Sales
$500,000
$300,000
Cost of Goods Sold
(350,000)
(270,000)
Gross Profit
$150,000
$ 30,000
Depreciation
(40,000)
Other Expenses
(60,000)
Income from Operations
Gain on Sale of Equipment to Scroll
Income before Taxes
$ 50,000
(10,000)
(15,000)
$
5,000
$
5,000
12,000
$ 62,000
page 355
Scroll purchased equipment from Pirn for $36,000 on January 1, 20X1, that is depreciated using the straight-line method over four years. What amount should
be reported as depreciation expense in Pirn’s 20X1 consolidated income statement?
a. $50,000
b. $47,000
c. $44,000
d. $41,000
E7–2
Multiple-Choice Questions on Intercompany Transactions
LO 7–2, 7–6
Select the correct answer for each of the following questions.
1. Upper Company holds 60 percent of Lower Company’s voting shares. During the preparation of consolidated financial statements for 20X5, the following
consolidation entry was made:
Investment in Lower
Land
Which of the following statements is correct?
a. Upper Company purchased land from Lower Company during 20X5.
b. Upper Company purchased land from Lower Company before January 1, 20X5.
c. Lower Company purchased land from Upper Company during 20X5.
d. Lower Company purchased land from Upper Company before January 1, 20X5.
10,000
10,000
2. Middle Company holds 60 percent of Bottom Corporation’s voting shares. Bottom has developed a new type of production equipment that appears to be quite
marketable. It spent $40,000 in developing the equipment; however, Middle agreed to purchase the production rights for the machine for $100,000. If the
intercompany sale occurred on January 1, 20X2, and the production rights are expected to have value for five years, at what amount should the rights be
reported in the consolidated balance sheet for December 31, 20X2?
a. $0
b. $32,000
c. $80,000
d. $100,000
Note: Questions 3 through 6 are based on the following information:
On January 1, 20X4, Gold Company purchased a computer with an expected economic life of five years. On January 1, 20X6, Gold sold the computer to TLK
Corporation and recorded the following entry:
Cash
39,000
Accumulated Depreciation
16,000
Computer Equipment
40,000
Gain on Sale of Equipment
15,000
TLK Corporation holds 60 percent of Gold’s voting shares. Gold reported net income of $45,000 including the gain on the sale of equipment, and TLK reported
income from its own operations of $85,000 for 20X6. There is no change in the estimated economic life of the equipment as a result of the intercompany transfer.
3. In the preparation of the 20X6 consolidated income statement, depreciation expense will be
a. Debited for $5,000 in the consolidation entries.
b. Credited for $5,000 in the consolidation entries.
c. Debited for $13,000 in the consolidation entries.
d. Credited for $13,000 in the consolidation entries.
4. In the preparation of the 20X6 consolidated balance sheet, computer equipment will be
a. Debited for $1,000.
b. Debited for $15,000.
c. Credited for $24,000.
d. Debited for $40,000.
5. Income assigned to the noncontrolling interest in the 20X6 consolidated income statement will be
page 356
a. $12,000.
b. $14,000.
c. $18,000.
d. $52,000.
6. Consolidated net income for 20X6 will be
a. $106,000.
b. $112,000.
c. $120,000.
d. $130,000.
E7–3
Consolidation Entries for Land Transfer
LO 7–3
Paragraph Corporation purchased land on January 1, 20X1, for $20,000. On June 10, 20X4, it sold the land to its subsidiary, Sentence Corporation, for $30,000.
Paragraph owns 60 percent of Sentence’s voting shares.
Required
a.
Give the worksheet consolidation entries needed to remove the effects of the intercompany sale of land in preparing the consolidated financial statements for
20X4 and 20X5.
b.
Give the worksheet consolidation entries needed on December 31, 20X4 and 20X5, if Sentence had initially purchased the land for $20,000 and then sold it to
Paragraph on June 10, 20X4, for $30,000.
E7–4
Intercompany Services
LO 7–1, 7–2
Power Corporation owns 75 percent of Swift Company’s stock. Swift provides health care services to its employees and those of Power. During 20X2, Power
recorded $45,000 as health care expense for medical care given to its employees by Swift. Swift’s costs incurred in providing the services to Power were $32,000.
Required
a.
By what amount will consolidated net income change when the intercompany services are eliminated in preparing Power’s consolidated statements for 20X2?
b.
What would be the impact of eliminating the intercompany services on consolidated net income if Power owned 100 percent of Swift’s stock rather than 75
percent? Explain.
c.
If in its consolidated income statement for 20X2 Power had reported total health care costs of $70,000, what was the cost to Swift of providing health care services
to its own employees?
E7–5
Consolidation Entries for Intercompany Services
LO 7–1, 7–2
On January 1, 20X5, Potter Corporation started using a wholly owned subsidiary to deliver all its sales overnight to its customers. During 20X5, Potter recorded
delivery service expense of $76,000 and made payments of $58,000 to the subsidiary.
Required
Give the worksheet consolidation entries related to the intercompany services needed on December 31, 20X5, to prepare consolidated financial statements.
E7–6
Consolidation Entries for Depreciable Asset Transfer: Year-End Sale
LO 7–6
Pam Corporation holds 70 percent ownership of Spray Enterprises. On December 31, 20X6, Spray paid Pam $40,000 for a truck that Pam had purchased for $45,000 on
January 1, 20X2. The truck was considered to have a 15-year life from January 1, 20X2, and no residual value. Both companies depreciate equipment using the
straight-line method.
Required
a.
Give the worksheet consolidation entry or entries needed on December 31, 20X6, to remove the effects of the intercompany sale.
b.
Give the worksheet consolidation entry or entries needed on December 31, 20X7, to remove the effects of the intercompany sale.
page 357
E7–7
Transfer of Land
LO 7–4
Paste Corporation owns 70 percent of Stick Corporation’s voting common stock. On March 12, 20X2, Stick sold land it had purchased for $140,000 to Paste for
$185,000. Paste plans to build a new warehouse on the property in 20X3.
Required
a.
Give the worksheet consolidation entries to remove the effects of the intercompany sale of land in preparing the consolidated financial statements at December 31,
20X2 and 20X3.
b.
Give the worksheet consolidation entries needed at December 31, 20X3 and 20X4, if Paste had initially purchased the land for $150,000 and sold it to Stick on
March 12, 20X2, for $180,000.
E7–8
Transfer of Depreciable Asset at Year-End
LO 7–5
Pitcher Corporation purchased 60 percent of Softball Corporation’s voting common stock on January 1, 20X1. On December 31, 20X5, Pitcher received $210,000 from
Softball for a truck Pitcher had purchased on January 1, 20X2, for $300,000. The truck is expected to have a 10-year useful life and no salvage value. Both companies
depreciate trucks on a straight-line basis.
Required
a.
Give the worksheet consolidation entry or entries needed at December 31, 20X5, to remove the effects of the intercompany sale.
b.
Give the worksheet consolidation entry or entries needed at December 31, 20X6, to remove the effects of the intercompany sale.
E7–9
Transfer of Depreciable Asset at Beginning of Year
LO 7–5
Pitcher Corporation purchased 60 percent of Softball Corporation’s voting common stock on January 1, 20X1. On January 1, 20X5, Pitcher received $245,000 from
Softball for a truck Pitcher had purchased on January 1, 20X2, for $300,000. The truck is expected to have a 10-year useful life and no salvage value. Both companies
depreciate trucks on a straight-line basis.
Required
a.
Give the worksheet consolidation entry or entries needed at December 31, 20X5, to remove the effects of the intercompany sale.
b.
Give the worksheet consolidation entry or entries needed at December 31, 20X6, to remove the effects of the intercompany sale.
E7–10
Sale of Equipment to Subsidiary in Current Period
LO 7–5
On January 1, 20X7, Pillow Corporation sold to Sheet Corporation equipment it had purchased for $150,000 and used for eight years. Pillow recorded a gain of
$14,000 on the sale. The equipment has a total useful life of 15 years and is depreciated on a straight-line basis. Pillow holds 70 percent of Sheet’s voting common
shares.
Required
a.
Give the journal entry made by Pillow on January 1, 20X7, to record the sale of equipment.
b.
Give the journal entries recorded by Sheet during 20X7 to record the purchase of equipment and year-end depreciation expense.
c.
Give the consolidation entry or entries related to the intercompany sale of equipment needed at December 31, 20X7, to prepare a full set of consolidated financial
statements.
d.
Give the consolidation entry or entries related to the equipment required at January 1, 20X8, to prepare a consolidated balance sheet only.
E7–11
Upstream Sale of Equipment in Prior Period
LO 7–6
Photo Industries has owned 80 percent of Shutter Corporation for many years. On January 1, 20X6, Photo paid Shutter $270,000 to acquire equipment that Shutter
had purchased on January 1, 20X3, for $300,000. The equipment is expected to have no scrap value and is depreciated over a 15-year useful life.
Photo reported operating earnings of $100,000 for 20X8 and paid dividends of $40,000. Shutter reported net income of $40,000 and paid dividends of $20,000 in
20X8.
page 358
Required
a.
Compute the amount reported as consolidated net income for 20X8.
b.
By what amount would consolidated net income change if the equipment sale had been a downstream sale rather than an upstream sale?
c.
Give the consolidation entry or entries required to eliminate the effects of the intercompany sale of equipment in preparing a full set of consolidated financial
statements at December 31, 20X8.
E7–12
Consolidation Entries for Midyear Depreciable Asset Transfer
LO 7–5
Playoff Corporation holds 90 percent ownership of Series Company. On July 1, 20X3, Playoff sold equipment that it had purchased for $30,000 on January 1, 20X1, to
Series for $28,000. The equipment’s original six-year estimated total economic life remains unchanged. Both companies use straight-line depreciation. The
equipment’s residual value is considered negligible.
Required
a.
Give the consolidation entry or entries in the consolidation worksheet prepared as of December 31, 20X3, to remove the effects of the intercompany sale.
b.
Give the consolidation entry or entries in the consolidation worksheet prepared as of December 31, 20X4, to remove the effects of the intercompany sale.
E7–13
Consolidated Net Income Computation
LO 7–2
Progeny Corporation owns 75 percent of Spawn Corporation’s voting common stock. Progeny reported income from its separate operations of $90,000 and $110,000
in 20X4 and 20X5, respectively. Spawn reported net income of $60,000 and $40,000 in 20X4 and 20X5, respectively.
Required
a.
Compute consolidated net income and the income assigned to the controlling interest for 20X4 and 20X5 if Progeny sold land with a book value of $95,000 to
Spawn for $120,000 on June 30, 20X4.
b.
Compute consolidated net income and the amount of income assigned to the controlling interest in the consolidated statements for 20X4 and 20X5 if Spawn sold
land with a book value of $95,000 to Progeny for $120,000 on June 30, 20X4.
E7–14
Consolidation Entries for Intercompany Transfers
LO 7–2, 7–3, 7–4
Post Delivery Service acquired at book value 80 percent of the voting shares of Script Real Estate Company. On that date, the fair value of the noncontrolling
interest was equal to 20 percent of Script’s book value. Script Real Estate reported common stock of $300,000 and retained earnings of $100,000. During 20X3, Post
Delivery provided courier services for Script Real Estate in the amount of $15,000. Also during 20X3, Script Real Estate purchased land for $1,000. It sold the land to
Post Delivery Service for $26,000 so that Post Delivery could build a new transportation center. Post Delivery reported $65,000 of operating income from its delivery
operations in 20X3. Script Real Estate reported net income of $40,000 and paid dividends of $10,000 in 20X3.
Required
a.
Compute consolidated net income for 20X3.
b.
Give all journal entries recorded by Post Delivery Service related to its investment in Script Real Estate assuming Post uses the fully adjusted equity method in
accounting for the investment.
c.
Give all consolidation entries required in preparing a consolidation worksheet as of December 31, 20X3.
E7–15
Sale of Building to Parent in Prior Period
LO 7–6
Pea Company purchased 70 percent of Split Company’s stock approximately 20 years ago. On December 31, 20X8, Pea purchased a building from Split for $300,000.
Split had purchased the building on January 1, 20X1, at a cost of $400,000 and used straight-line depreciation on an expected life of 20 years. The asset’s total
estimated economic life is unchanged as a result of the intercompany sale.
page 359
Required
a.
What amount of depreciation expense on the building will Pea report for 20X9?
b.
What amount of depreciation expense would Split have reported for 20X9 if it had continued to own the building?
c.
Give the consolidation entry or entries needed to eliminate the effects of the intercompany building transfer in preparing a full set of consolidated financial
statements at December 31, 20X9.
d.
What amount of income will be assigned to the noncontrolling interest in the consolidated income statement for 20X9 if Split reports net income of $40,000 for
20X9?
e.
Split reports assets with a book value of $350,000 and liabilities of $150,000 at January 1, 20X9, and reports net income of $40,000 and dividends of $15,000 for
20X9. What amount will be assigned to the noncontrolling interest in the consolidated balance sheet at December 31, 20X9, assuming the fair value of the
noncontrolling interest at the date of acquisition was equal to 30 percent of Split Company’s book value?
E7–16
Intercompany Sale at a Loss
LO 7–5
Parent Company holds 90 percent of Surrogate Company’s voting common shares. On December 31, 20X8, Parent recorded a loss of $16,000 on the sale of
equipment to Surrogate. At the time of the sale, the equipment’s estimated remaining economic life was eight years.
Required
a.
Will consolidated net income be increased or decreased when consolidation entries associated with the sale of equipment are made at December 31, 20X8? By
what amount?
b.
Will consolidated net income be increased or decreased when consolidation entries associated with the sale of equipment are made at December 31, 20X9? By
what amount?
E7–17
Consolidation Entries Following Intercompany Sale at a Loss
LO 7–6
Pocket Corporation holds 70 percent of Strap Company’s voting common stock. On January 1, 20X2, Strap paid $300,000 to acquire a building with a 15-year
expected economic life. Strap uses straight-line depreciation for all depreciable assets. On December 31, 20X7, Pocket purchased the building from Strap for
$144,000. Pocket reported income, excluding investment income from Strap, of $125,000 and $150,000 for 20X7 and 20X8, respectively. Strap reported net income of
$15,000 and $40,000 for 20X7 and 20X8, respectively.
Required
a.
Give the appropriate consolidation entry or entries needed to eliminate the effects of the intercompany sale of the building in preparing consolidated financial
statements for 20X7.
b.
Compute the amount to be reported as consolidated net income for 20X7 and the income to be allocated to the controlling interest.
c.
Give the appropriate consolidation entry or entries needed to eliminate the effects of the intercompany sale of the building in preparing consolidated financial
statements for 20X8.
d.
Compute consolidated net income and the amount of income assigned to the controlling shareholders in the consolidated income statement for 20X8.
E7–18
Multiple Transfers of Asset
LO 7–4
Swanson Corporation purchased land from Clayton Corporation for $240,000 on December 20, 20X3. This purchase followed a series of transactions between
Swanson-controlled subsidiaries. On February 7, 20X3, Sullivan Corporation purchased the land from a nonaffiliate for $145,000. It sold the land to Kolder Company
for $130,000 on October 10, 20X3, and Kolder sold the land to Clayton for $180,000 on November 27, 20X3. Swanson has control of the following companies:
Subsidiary
Level of Ownership
20X3 Net Income
Sullivan Corporation
80 percent
$120,000
Kolder Company
70 percent
60,000
Clayton Corporation
90 percent
80,000
Swanson reported income from its separate operations of $150,000 for 20X3.
page 360
Required
a.
At what amount should the land be reported in the consolidated balance sheet as of December 31, 20X3?
b.
What amount of gain or loss on sale of land should be reported in the consolidated income statement for 20X3?
c.
What amount of income should be assigned to the controlling shareholders in the consolidated income statement for 20X3?
d.
Give any consolidation entry related to the land that should appear in the worksheet used to prepare consolidated financial statements for 20X3.
E7–19
Consolidation Entry in Period of Transfer
LO 7–6
Plumber Corporation owns 60 percent of Socket Corporation’s voting common stock. On December 31, 20X4, Plumber paid Socket $276,000 for dump trucks Socket
had purchased on January 1, 20X2. Both companies use straight-line depreciation. The consolidation entry included in preparing consolidated financial statements
at December 31, 20X4, was
Trucks
24,000
Gain on Sale of Trucks
36,000
Accumulated Depreciation
60,000
Required
a.
What amount did Socket pay to purchase the trucks on January 1, 20X2?
b.
What was the economic life of the trucks on January 1, 20X2?
c.
Give the worksheet consolidation entry needed in preparing the consolidated financial statements at December 31, 20X5.
E7–20
Consolidation Entry Computation
LO 7–6
Passport Manufacturing purchased an ultrasound drilling machine with a remaining 10-year economic life from a 70 percent-owned subsidiary for $360,000 on
January 1, 20X6. Both companies use straight-line depreciation. The subsidiary recorded the following entry when it sold the machine to Stern:
Cash
360,000
Accumulated Depreciation
150,000
Equipment
450,000
Gain on Sale of Equipment
60,000
Required
Give the worksheet consolidation entry or entries needed to remove the effects of the intercompany sale of equipment when consolidated financial statements are
prepared as of (a) December 31, 20X6, and (b) December 31, 20X7.
E7–21
Using the Consolidation Entry to Determine Account Balances
LO 7–6
Pastel Corporation acquired a controlling interest in Somber Corporation in 20X5 for an amount equal to its underlying book value. At the date of acquisition, the
fair value of the noncontrolling interest was equal to its proportionate share of the book value of Somber Corporation. In preparing a consolidated balance sheet
worksheet at January 1, 20X9, Pastel’s controller included the following consolidation entry:
Equipment
53,500
Investment in Somber Corp.
9,450
NCI in NA of Somber Corp.
1,050
Accumulated Depreciation
64,000
A note at the bottom of the consolidation worksheet at January 1, 20X9, indicates the equipment was purchased from a nonaffiliate on January 1, 20X1, for $120,000
and was sold to an affiliate on December 31, 20X8. The equipment is being depreciated on a 15-year straight-line basis. Somber reported stock outstanding of
$300,000 and retained earnings of $200,000 at January 1, 20X9. Somber reported net income of $25,000 and paid dividends of $6,000 for 20X9.
page 361
Required
a.
What percentage ownership of Somber Corporation does Pastel hold?
b.
Was the parent or subsidiary the owner prior to the intercompany sale of equipment? Explain.
c.
What was the intercompany transfer price of the equipment on December 31, 20X8?
d.
What amount of income will be assigned to the noncontrolling interest in the consolidated income statement for 20X9?
e.
Assuming Pastel and Somber report depreciation expense of $15,000 and $9,000, respectively, for 20X9, what depreciation amount will be reported in the
consolidated income statement for 20X9?
f.
Give all remaining consolidation entries needed at December 31, 20X9, to prepare a complete set of consolidated financial statements.
E7–22
Intercompany Sale of Services
LO 7–1, 7–2
Plastic Corporation purchased management consulting services from its 75 percent-owned subsidiary, Spoon Inc. During 20X3, Plastic paid Spoon $123,200 for its
services. For the year 20X4, Spoon billed Plastic $138,700 for such services and collected all but $6,600 by year-end. Spoon’s labor cost and other associated costs
for the employees providing services to Plastic totaled $91,000 in 20X3 and $112,000 in 20X4. Plastic reported $2,342,000 of income from its own separate operations
for 20X4, and Spoon reported net income of $631,000.
Required
a.
Present all consolidation entries related to the intercompany sale of services that would be needed in the consolidation worksheet used to prepare a complete set
of consolidated financial statements for 20X4.
b.
Compute consolidated net income for 20X4 and the amount of income assigned to the controlling interest.
E7–23A
Modified Equity Method and Cost Method
LO 7–3, 7–6
Passenger Products purchased 65 percent of Seat Sales Company’s stock at underlying book value on January 1, 20X3. At that date, the fair value of the
noncontrolling interest was equal to 35 percent of the book value of Seat Sales. Seat Sales reported shares outstanding of $300,000 and retained earnings of
$100,000. During 20X3, Seat Sales reported net income of $50,000 and paid dividends of $5,000. In 20X4, Seat Sales reported net income of $70,000 and paid
dividends of $20,000.
The following transactions occurred between Passenger Products and Seat Sales in 20X3 and 20X4:
1. Seat Sales sold camera equipment to Passenger for a $40,000 profit on December 31, 20X3. The equipment had a five-year estimated economic life remaining at
the time of intercompany transfer and is depreciated on a straight-line basis.
2. Passenger sold land costing $30,000 to Seat Sales on June 30, 20X4, for $41,000.
Required
a.
Assuming that Passenger uses the modified equity method to account for its investment in Seat Sales:
(1) Give the journal entries recorded on Passenger’s books in 20X4 related to its investment in Seat Sales.
(2) Give all consolidation entries needed to prepare a consolidation worksheet for 20X4.
b.
Assuming that Passenger uses the cost method to account for its investment in Seat Sales:
(1) Give the journal entries recorded on Passenger’s books in 20X4 related to its investment in Seat Sales.
(2) Give all consolidation entries needed to prepare a consolidation worksheet for 20X4.
PROBLEMS
P7–24
Computation of Consolidated Net Income
LO 7–3, 7–4
Package Corporation acquired 90 percent ownership of Sack Grain Company on January 1, 20X4, for $108,000 when the fair value of Sack’s net assets was $10,000
higher than its $110,000 book value. The increase in value was attributed to amortizable assets with a remaining life of 10 years. At that date, the fair value of the
noncontrolling interest was equal to $12,000.
page 362
During 20X4, Sack sold land to Package at a $7,000 profit. Sack Grain reported net income of $19,000 and paid dividends of $4,000 in 20X4. Package reported
income, exclusive of its income from Sack Grain, of $34,000 and paid dividends of $15,000 in 20X4.
Required
a.
Compute the amount of income assigned to the controlling interest in the consolidated income statement for 20X4.
b.
By what amount will the 20X4 income assigned to the controlling interest increase or decrease if the sale of land had been from Package to Sack Grain, the gain on
the sale of land had been included in Package’s $34,000 income, and the $19,000 was income from operations of Sack Grain?
P7–25
Subsidiary Net Income
LO 7–6
Pizza Corporation acquired 75 percent of Slice Corporation’s voting common stock on January 1, 20X4, for $348,000, when the fair value of its net identifiable assets
was $464,000 and the fair value of the noncontrolling interest was $116,000. Slice reported common stock outstanding of $150,000 and retained earnings of $270,000.
The excess of fair value over book value of Slice’s net assets was attributed to amortizable assets with a remaining life of 10 years. On December 31, 20X4, Slice sold
a building to Pizza and recorded a gain of $20,000. Income assigned to the noncontrolling shareholders in the 20X4 consolidated income statement was $17,500.
Required
a.
Compute the amount of net income Slice reported for 20X4.
b.
Compute the amount reported as consolidated net income if Pizza reported operating income of $234,000 for 20X4.
c.
Compute the amount of income assigned to the controlling interest in the 20X4 consolidated income statement.
P7–26
Transfer of Asset from One Subsidiary to Another
LO 7–6
Pelts Company holds a total of 70 percent of Bugle Corporation and 80 percent of Cook Products Corporation stock. Bugle purchased a warehouse with an expected
life of 20 years on January 1, 20X1, for $40,000. On January 1, 20X6, it sold the warehouse to Cook Products for $45,000.
Required
Complete the following table showing selected information that would appear in the separate 20X6 income statements and balance sheets of Bugle Corporation and
Cook Products Corporation and in the 20X6 consolidated financial statements.
Bugle
Corporation
Depreciation expense
Fixed assets—warehouse
Accumulated depreciation
Gain on sale of warehouse
P7–27
Consolidation Entry
Cook Products
Corporation
Consolidated
Entity
LO 7–6
In preparing its consolidated financial statements at December 31, 20X7, the following consolidation entries were included in the consolidation worksheet of Powder
Corporation:
Buildings
140,000
Gain on Sale of Building
28,000
Accumulated Depreciation
Accumulated Depreciation
168,000
2,000
Depreciation Expense
2,000
Powder owns 60 percent of Snow Corporation’s voting common stock. On January 1, 20X7, Snow sold Powder a building it had purchased for $600,000 on January
1, 20X1, and depreciated on a 20-year straight-line basis. Powder recorded depreciation for 20X7 using straight-line depreciation and the same useful life and
residual value as Snow.
page 363
Required
a.
What amount did Powder pay Snow for the building?
b.
What amount of accumulated depreciation did Snow report at January 1, 20X7, prior to the sale?
c.
What annual depreciation expense did Snow record prior to the sale?
d.
What expected residual value did Snow use in computing its annual depreciation expense?
e.
What amount of depreciation expense did Powder record in 20X7?
f.
If Snow reported net income of $80,000 for 20X7, what amount of income will be assigned to the noncontrolling interest in the consolidated income statement for
20X7?
g.
If Snow reported net income of $65,000 for 20X8, what amount of income will be assigned to the noncontrolling interest in the consolidated income statement for
20X8?
P7–28
Multiple-Choice Questions
LO 7–4, 7–6
Select the correct answer for each of the following questions.
1. In the preparation of a consolidated income statement:
a. Income assigned to noncontrolling shareholders always is computed as a pro rata portion of the reported net income of the consolidated entity.
b. Income assigned to noncontrolling shareholders always is computed as a pro rata portion of the reported net income of the subsidiary.
c. Income assigned to noncontrolling shareholders in the current period is likely to be less than a pro rata portion of the reported net income of the subsidiary
in the current period if the subsidiary had an unrealized gain on an intercompany sale of depreciable assets in the preceding period. Assume the
depreciable asset was subsequently sold in the current period.
d. Income assigned to noncontrolling shareholders in the current period is likely to be more than a pro rata portion of the reported net income of the
subsidiary in the current period if the subsidiary had an unrealized gain on an intercompany sale of depreciable assets in the preceding period. Assume the
depreciable asset was subsequently sold in the current period.
2. When a 90 percent-owned subsidiary records a gain on the sale of land to an affiliate during the current period and the land is not resold before the end of the
period:
a. Ninety percent of the gain will be excluded from consolidated net income.
b. Consolidated net income will be increased by the full amount of the gain.
c. A proportionate share of the unrealized gain will be excluded from income assigned to noncontrolling interest.
d. The full amount of the unrealized gain will be excluded from income assigned to noncontrolling interest.
3. Minor Company sold land to Major Company on November 15, 20X4, and recorded a gain of $30,000 on the sale. Major owns 80 percent of Minor’s common
shares. Which of the following statements is correct?
a. A proportionate share of the $30,000 must be treated as a reduction of income assigned to the noncontrolling interest in the consolidated income statement
unless the land is resold to a nonaffiliate in 20X4.
b. The $30,000 will not be treated as an adjustment in computing income assigned to the noncontrolling interest in the consolidated income statement in 20X4
unless the land is resold to a nonaffiliate in 20X4.
c. In computing consolidated net income, it does not matter whether the land is or is not resold to a nonaffiliate before the end of the period; the $30,000 will
not affect the computation of consolidated net income in 20X4 because the profits are on the subsidiary’s books.
d. Minor’s trial balance as of December 31, 20X4, should be adjusted to remove the $30,000 gain because the gain is not yet realized.
4. Lewis Company owns 80 percent of Tomassini Corporation’s stock. You are told that Tomassini has sold equipment to Lewis and that the following
consolidation entries are needed to prepare consolidated statements for 20X9:
Equipment
20,000
Gain on Sale of Equipment
40,000
Accumulated Depreciation
60,000
page 364
Accumulated Depreciation
Depreciation Expense
5,000
5,000
Which of the following is incorrect?
a.
The parent paid $40,000 in excess of the subsidiary’s carrying amount to acquire the asset.
b.
From a consolidated viewpoint, depreciation expense as Lewis recorded it is overstated.
c.
The asset transfer occurred in 20X9 before the end of the year.
d.
Consolidated net income will be reduced by $40,000 when these consolidation entries are made.
P7–29
Intercompany Services Provided to Subsidiary
LO 7–1, 7–2
During 20X4, Plate Company paid its employees $80,000 for work done in helping its wholly owned subsidiary build a new office building that was completed on
December 31, 20X4. Plate recorded the $110,000 payment from the subsidiary for the work done as service revenue. The subsidiary included the payment in the cost
of the building and is depreciating the building over 25 years with no assumed residual value. Plate uses the fully adjusted equity method.
Required
Present the consolidation entries needed at December 31, 20X4 and 20X5, to prepare Plate’s consolidated financial statements.
P7–30
Consolidated Net Income with Intercompany Transfers
LO 7–4, 7–5
In its 20X7 consolidated income statement, Plate Development Company reported consolidated net income of $961,000 and $39,000 of income assigned to the 30
percent noncontrolling interest in its only subsidiary, Subsidence Mining Inc. During the year, Subsidence had sold a previously mined parcel of land to Plate for a
new housing development; the sales price to Plate was $500,000, and the land had a carrying amount at the time of sale of $560,000. At the beginning of the previous
year, Plate had sold excavation and grading equipment to Subsidence for $240,000; the equipment had a remaining life of six years as of the date of sale and a book
value of $210,000. The equipment originally had cost $350,000 when Plate purchased it on January 2, 20X2. The equipment never was expected to have any salvage
value.
Plate had acquired 70 percent of the voting shares of Subsidence eight years earlier when the fair value of its net assets was $200,000 higher than book value,
and the fair value of the noncontrolling interest was $60,000 more than a proportionate share of the book value of Subsidence’s net assets. All the excess over the
book value was attributable to intangible assets with a remaining life of 10 years from the date of combination. Both parent and subsidiary use straight-line
amortization and depreciation. Assume Plate uses the fully adjusted equity method.
Required
a.
Present the journal entry made by Plate to record the sale of equipment in 20X6 to Subsidence.
b.
Present all consolidation entries related to the intercompany transfers of land and equipment that should appear in the consolidation worksheet used to prepare a
complete set of consolidated financial statements for 20X7.
c.
Compute Subsidence’s 20X7 reported net income.
d.
Compute Plate’s 20X7 income from its own separate operations, excluding any investment income from its investment in Subsidence Mining.
P7–31
Preparation of Consolidated Balance Sheet
LO 7–4, 7–5
Pork Company owns 60 percent of Swine Corporation’s voting shares, purchased on May 17, 20X1, at book value. At that date, the fair value of the noncontrolling
interest was equal to 40 percent of the book value of Swine Corporation. The companies’ permanent accounts on December 31, 20X6, contained the following
balances:
page 365
Pork
Company
Swine
Corporation
$101,000
$ 20,000
80,000
40,000
Land
150,000
90,000
Buildings & Equipment
400,000
300,000
Investment in Swine Corporation Stock
141,000
Cash and Receivables
Inventory
872,000
$450,000
$135,000
$ 85,000
90,000
25,000
Notes Payable
200,000
90,000
Common Stock
100,000
200,000
Retained Earnings
347,000
50,000
$872,000
$450,000
Accumulated Depreciation
Accounts Payable
On January 1, 20X2, Pork paid $100,000 for equipment with a 10-year expected total economic life. The equipment was depreciated on a straight-line basis with no
residual value. Swine purchased the equipment from Pork on December 31, 20X4, for $91,000. Assume Swine did not change the remaining estimated useful life of
the equipment.
Swine sold land it had purchased for $30,000 on February 23, 20X4, to Pork for $20,000 on October 14, 20X5. Assume Pork uses the fully adjusted equity method.
Required
a.
Prepare a consolidated balance sheet worksheet in good form as of December 31, 20X6.
b.
Prepare a consolidated balance sheet as of December 31, 20X6.
P7–32
Consolidation Worksheet in Year of Intercompany Transfer
LO 7–4, 7–5
Prime Company holds 80 percent of Suspect Company’s stock, acquired on January 1, 20X2, for $160,000. On the acquisition date, the fair value of the
noncontrolling interest was $40,000. Suspect reported retained earnings of $50,000 and had $100,000 of common stock outstanding. Prime uses the fully adjusted
equity method in accounting for its investment in Suspect.
Trial balance data for the two companies on December 31, 20X6, are as follows:
page 366
Additional Information
1. At the date of combination, the book values and fair values of all separately identifiable assets and liabilities of Suspect were the same. At December 31, 20X6,
the management of Prime reviewed the amount attributed to goodwill as a result of its purchase of Suspect stock and concluded an impairment loss of $18,000
should be recognized in 20X6 and shared proportionately between the controlling and noncontrolling shareholders.
2. On January 1, 20X5, Suspect sold land that had cost $8,000 to Prime for $18,000.
3. On January 1, 20X6, Prime sold to Suspect equipment that it had purchased for $75,000 on January 1, 20X1. The equipment has a total economic life of 15 years
and was sold to Suspect for $70,000. Both companies use straight-line depreciation.
4. There was $7,000 of intercompany receivables and payables on December 31, 20X6.
Required
a.
Give all consolidation entries needed to prepare a consolidation worksheet for 20X6.
b.
Prepare a three-part worksheet for 20X6 in good form.
c.
Prepare a consolidated balance sheet, income statement, and retained earnings statement for 20X6.
P7–33
Consolidation Worksheet in Year Following Intercompany Transfer
LO 7–4, 7–5
Prime Company holds 80 percent of Suspect Company’s stock, acquired on January 1, 20X2, for $160,000. On the date of acquisition, Suspect reported retained
earnings of $50,000 and $100,000 of common stock outstanding, and the fair value of the noncontrolling interest was $40,000. Prime uses the fully adjusted equity
method in accounting for its investment in Suspect.
Trial balance data for the two companies on December 31, 20X7, are as follows:
Additional Information
1. At the date of combination, the book values and fair values of Suspect’s separately identifiable assets and liabilities were equal. The full amount of the
increased value of the entity was attributed to goodwill. At December 31, 20X6, the management of Prime reviewed the amount attributed to goodwill as a result
of its purchase of Suspect stock and recognized an impairment loss of $18,000. No further impairment occurred in 20X7.
2. On January 1, 20X5, Suspect sold land for $18,000 that had cost $8,000 to Prime.
3. On January 1, 20X6, Prime sold to Suspect equipment that it had purchased for $75,000 on January 1, 20X1. The equipment has a total 15-year economic life and
was sold to Suspect for $70,000. Both companies use straight-line depreciation.
4. Intercompany receivables and payables total $4,000 on December 31, 20X7.
page 367
Required
a.
Prepare a reconciliation between the balance in Prime’s Investment in Suspect Company Stock account reported on December 31, 20X7, and Suspect’s book value.
b.
Prepare all worksheet consolidation entries needed as of December 31, 20X7, and complete a three-part consolidation worksheet for 20X7.
P7–34
Intercompany Sales in Prior Years
LO 7–4, 7–5
On January 1, 20X5, Pond Corporation acquired 80 percent of Skate Company’s stock by issuing common stock with a fair value of $180,000. At that date, Skate
reported net assets of $150,000. The fair value of the noncontrolling interest was $45,000. Assume Pond uses the fully adjusted equity method. The balance sheets
for Pond and Skate at January 1, 20X8, and December 31, 20X8, and income statements for 20X8 were reported as follows:
Additional Information
1. In 20X2, Skate developed a patent for a high-speed drill bit that Pond planned to market extensively. In accordance with generally accepted accounting
standards, Skate charges all research and development costs to expense in the year the expenses are incurred. At January 1, 20X5, the market value of the
patent rights was estimated to be $50,000. Pond believes the patent will be of value for the next 20 years. The remainder of the differential is assigned page 368
to buildings and equipment, which also had a 20-year estimated economic life at January 1, 20X5. All of Skate’s other assets and liabilities identified
by Pond at the date of acquisition had book values and fair values that were relatively equal.
2. On December 31, 20X7, Pond sold a building to Skate for $65,000 that it had purchased for $125,000 and depreciated on a straight-line basis over 25 years. At
the time of sale, Pond reported accumulated depreciation of $75,000 and a remaining life of 10 years.
3. On July 1, 20X6, Skate sold land that it had purchased for $22,000 to Pond for $35,000. Pond is planning to build a new warehouse on the property prior to the
end of 20X9.
4. Both Pond and Skate paid dividends in 20X8.
Required
a.
Give all consolidation entries required to prepare a three-part consolidation working paper at December 31, 20X8.
b.
Prepare a three-part worksheet for 20X8 in good form.
P7–35
Intercompany Sale of Land and Depreciable Asset
LO 7–3, 7–6
Putt Corporation acquired 70 percent of Slice Company’s voting common stock on January 1, 20X3, for $158,900. Slice reported common stock outstanding of
$100,000 and retained earnings of $85,000. The fair value of the noncontrolling interest was $68,100 at the date of acquisition. Buildings and equipment held by Slice
had a fair value $25,000 higher than book value. The remainder of the differential was assigned to a copyright held by Slice. Buildings and equipment had a 10-year
remaining life and the copyright had a 5-year life at the date of acquisition.
Trial balances for Putt and Slice on December 31, 20X5, are as follows:
Putt sold land it had purchased for $21,000 to Slice on September 20, 20X4, for $32,000. Slice plans to use the land for future plant expansion. On January 1, 20X5,
Slice sold equipment to Putt for $91,600. Slice purchased the equipment on January 1, 20X3, for $100,000 and depreciated it on a 10-year basis, including an
estimated residual value of $10,000. The residual value and estimated economic life of the equipment remained unchanged as a result of the transfer, and page 369
both companies use straight-line depreciation. Assume Putt uses the fully adjusted equity method.
Required
a.
Compute the amount of income assigned to the noncontrolling interest in the consolidated income statement for 20X5.
b.
Prepare a reconciliation between the balance in the Investment in Slice Company Stock account reported by Putt at December 31, 20X5, and the underlying book
value of net assets reported by Slice at that date.
c.
Give all consolidation entries needed to prepare a full set of consolidated financial statements at December 31, 20X5, for Putt and Slice.
d.
Prepare a three-part worksheet for 20X5 in good form.
P7–36
Incomplete Data
LO 7–3, 7–6
Partial trial balance data for Profile Corporation, Shadow Company, and the consolidated entity at December 31, 20X7, are as follows:
Item
Profile
Corporation
Shadow
Company
Consolidated
Entity
Cash
$ 65,300
$ 25,000
$ 90,300
(d)
35,000
126,000
Inventory
160,000
75,000
235,000
Buildings & Equipment
345,000
150,000
(i)
70,000
90,000
153,000
Accounts Receivable
Land
Investment in Shadow Company
Cost of Goods Sold
Depreciation Expense
(f)
230,000
195,000
425,000
45,000
10,000
52,000
Amortization Expense
(e)
Miscellaneous Expense
18,000
15,000
33,000
Dividends Declared
25,000
20,000
25,000
Income to Noncontrolling Interest
(l)
Copyrights
9,000
Total Debits
$1,180,900
$615,000
$1,674,200
Accumulated Depreciation
$ 180,000
$ 80,000
$ (j)
25,000
85,000
101,000
100,000
50,000
(a)
(b)
70,000
140,000
375,800
80,000
(k)
(c)
593,000
Accounts Payable
Common Stock
Additional Paid-In Capital
Retained Earnings
Income from Shadow Company
Sales
10,100
343,000
Gain on Sale of Land
(g)
(h)
Noncontrolling Interest
Total Credits
86,400
$1,180,900
$615,000
$1,674,200
Additional Information
1. Profile Corporation acquired 60 percent ownership of Shadow Company on January 1, 20X4, for $106,200. Shadow reported net assets of $150,000 at that date,
and the fair value of the noncontrolling interest was estimated to be $70,800. The full amount of the differential at acquisition is assigned to copyrights that are
being amortized over a six-year life.
2. On August 13, 20X7, Profile sold land to Shadow for $28,000. Profile also has accounts receivable from Shadow on services performed prior to the end of 20X7.
3. Shadow sold equipment it had purchased for $60,000 on January 1, 20X4, to Profile for $45,000 on January 1, 20X6. The equipment is depreciated on a straightline basis and had a total expected useful life of five years when Shadow purchased it. No change in life expectancy resulted from the intercompany transfer.
Assume Profile uses the fully adjusted equity method.
4. Assume Profile Corp. does not use the optional accumulation depreciation consolidation entry.
page 370
Required
Compute the dollar amount for each of the balances identified by a letter.
P7–37
Intercompany Sale of Equipment at a Loss in Prior Period
LO 7–6
Server Corporation was created on January 1, 20X0, to develop computer software. On January 1, 20X5, Proxy Company acquired 90 percent of Server’s common
stock at its underlying book value. At that date, the fair value of the noncontrolling interest was equal to 10 percent of the book value of Server Corporation. Trial
balances for Proxy and Server on December 31, 20X9, follow:
On January 1, 20X7, Server sold equipment to Proxy for $48,000. Server had purchased the equipment for $90,000 on January 1, 20X5, and was depreciating it on
a straight-line basis with a 10-year expected life and no anticipated scrap value. The equipment’s total expected life is unchanged as a result of the intercompany
sale. Assume Proxy uses the fully adjusted equity method.
Required
a.
Give all consolidation entries required to prepare a three-part consolidated working paper at December 31, 20X9.
b.
Prepare a three-part worksheet for 20X9 in good form.
P7–38
Comprehensive Problem: Intercompany Transfers
LO 7–1, 7–2, 7–3, 7–6
Prince Corporation holds 75 percent of the common stock of Sword Distributors Inc., purchased on December 31, 20X1, for $2,340,000. At the date of acquisition,
Sword reported common stock with a par value of $1,000,000, additional paid-in capital of $1,350,000, and retained earnings of $620,000. The fair value of the
noncontrolling interest at acquisition was $780,000. The differential at acquisition was attributable to the following items:
Inventory (sold in 20X2)
$ 30,000
Land
56,000
Goodwill
64,000
Total Differential
$150,000
page 371
During 20X2, Prince sold a plot of land that it had purchased several years before to Sword at a gain of $23,000; Sword continues to hold the land. In 20X6,
Prince and Sword entered into a five-year contract under which Prince provides management consulting services to Sword on a continuing basis; Sword pays
Prince a fixed fee of $80,000 per year for these services. At December 31, 20X8, Sword owed Prince $20,000 as the final 20X8 quarterly payment under the contract.
On January 2, 20X8, Prince paid $250,000 to Sword to purchase equipment that Sword was then carrying at $290,000. Sword had purchased that equipment on
December 27, 20X2, for $435,000. The equipment is expected to have a total 15-year life and no salvage value. The amount of the differential assigned to goodwill
has not been impaired.
At December 31, 20X8, trial balances for Prince and Sword appeared as follows:
As of December 31, 20X8, Sword had declared but not yet paid its fourth-quarter dividend of $5,000. Both companies use straight-line depreciation and amortization.
Prince uses the fully adjusted equity method to account for its investment in Sword.
Required
a.
Compute the amount of the differential as of January 1, 20X8.
b.
Verify the balance in Prince’s Investment in Sword Distributors account as of December 31, 20X8.
c.
Present all consolidation entries that would appear in a three-part consolidation worksheet as of December 31, 20X8.
d.
Prepare and complete a three-part worksheet for the preparation of consolidated financial statements for 20X8.
P7–39A
Modified Equity Method
Multiple Transfers
Computation
of
Retained
Earnings
Following
LO 7–4, 7–5
Private Company acquired 80 percent of Secret Corporation’s common stock on January 1, 20X4, for $280,000. The fair value of the noncontrolling interest was
$70,000 at the date of acquisition. Private’s corporate controller has lost the consolidation files for the past three years and has asked you to compute the proper
retained earnings balances for the consolidated entity at January 1, 20X8, and December 31, 20X8. The controller has been able to determine the following:
1. The book value of Secret’s net assets at January 1, 20X4, was $290,000, and the fair value of its net assets was $325,000. This difference was due to an increase
in the value of equipment. All depreciable assets had a remaining life of 10 years at the date of combination. At December 31, 20X8, Private’s management
reviewed the amount attributed to goodwill as a result of its purchase of Secret common stock and concluded that an impairment loss of $17,500 page 372
should be recognized in 20X8 and shared proportionately between the controlling and noncontrolling shareholders.
2. Private uses the modified equity method in accounting for its investment in Secret.
3. Secret has reported net income of $30,000 and paid dividends of $20,000 each year since Private purchased its ownership.
4. Private reported retained earnings of $450,000 in its December 31, 20X7, balance sheet. For 20X8, Private reported operating income of $65,000 and paid
dividends of $45,000.
5. Secret sold land costing $40,000 to Private for $56,000 on December 31, 20X7.
6. On January 1, 20X6, Private sold depreciable assets with a remaining useful life of 10 years to Secret and recorded a $22,000 gain on the sale.
Required
Compute the appropriate amounts to be reported as consolidated retained earnings at January 1, 20X8, and December 31, 20X8.
P7–40A
Consolidation Worksheet with Intercompany Transfers (Modified Equity
Method)
LO 7–1, 7–3, 7–6
Pot Company acquired 65 percent of Seed Corporation’s voting common stock on June 20, 20X2, at underlying book value. At that date, the fair value of the
noncontrolling interest was equal to 35 percent of the book value of Seed Corporation. The balance sheets and income statements for the companies at December
31, 20X4, are as follows:
POT COMPANY AND SEED CORPORATION
Balance Sheets
December 31, 20X4
Item
Pot Company
Seed Corp.
Cash
$ 32,500
$ 22,000
Accounts Receivable
62,000
37,000
Inventory
95,000
71,000
Land
40,000
15,000
Buildings & Equipment (net)
200,000
125,000
Investment in Seed Corp.
110,500
Total Assets
$540,000
$270,000
Accounts Payable
$ 35,000
$ 20,000
Bonds Payable
180,000
80,000
Common Stock, $5 par value
100,000
60,000
Retained Earnings
225,000
110,000
$540,000
$270,000
Total Liabilities & Stockholders’ Equity
page 373
Additional Information
1. Pot uses the modified equity method in accounting for its investment in Seed.
2. During 20X4, Pot charged Seed $24,000 for consulting services provided to Seed during the year. The services cost Pot $17,000.
3. On January 1, 20X4, Seed sold Pot a building for $13,200 above its carrying value on Seed’s books. The building had a 12-year remaining economic life at the
time of transfer.
4. On June 14, 20X4, Pot sold land it had purchased for $3,000 to Seed for $7,000. Seed continued to hold the land at December 31, 20X4.
Required
a.
Give all consolidation entries needed to prepare a full set of consolidated financial statements for 20X4.
b.
Prepare a consolidation worksheet for 20X4.
c.
Prepare the 20X4 consolidated balance sheet, income statement, and retained earnings statement.
P7–41A
Modified Equity Method
LO 7–6
Using the data in P7-33, on December 31, 20X7, Prime Company recorded the following entry on its books to adjust its investment in Suspect Company from the
fully adjusted equity method to the modified equity method:
Income from Suspect Company
2,000
Investment in Suspect Company
38,400
Retained Earnings
40,400
Required
a.
Adjust the data reported by Prime in the trial balance in P7-33 for the effects of the adjusting entry presented above.
b.
Prepare the journal entries that would have been recorded on Prime’s books during 20X7 if it had always used the modified equity method.
c.
Prepare all consolidation entries needed to complete a consolidation worksheet as of December 31, 20X7, assuming Prime has used the modified equity method.
d.
Complete a three-part consolidation worksheet as of December 31, 20X7.
P7–42A
Cost Method
LO 7–6
The trial balance data presented in P7-33 can be converted to reflect use of the cost method by inserting the following amounts in place of those presented for Prime
Company:
Investment in Suspect Company $160,000
Beginning Retained Earnings
348,000
Income from Suspect Company
0
Dividend Income
28,000
Required
a.
Prepare the journal entries that would have been recorded on Prime’s books during 20X7 under the cost method.
b.
Prepare all consolidation entries needed to complete a consolidation worksheet as of December 31, 20X7, assuming Prime has used the cost method.
c.
Complete a three-part consolidation worksheet as of December 31, 20X7.
1
To view a video explanation of this topic, visit advancedstudyguide.com.
2
To avoid additional complexity, we assume the land’s fair value is equal to its book value on the business
combination date. As a result, there is no differential related to the land.
3
To avoid additional complexity, we assume the equipment’s fair value is equal to its book value on the
business combination date. As a result, there is no differential related to the equipment.
*
Note that this is the subsidiary’s retained earnings balance. The subsidiary does not adjust for the
deferral of unrealized gain because this adjustment is made on the consolidation worksheet, not in the
records of the subsidiary.
†
Note that this is the subsidiary’s retained earnings balance. The subsidiary does not adjust for the
deferral of the remaining unrealized gain because this adjustment is made on the consolidation worksheet, not
in the records of the subsidiary.
page 374
8
Intercompany Indebtedness
Multicorporate Entities
Business Combinations
Consolidation Concepts and Procedures
Intercompany Transfers
Additional Consolidation Issues
Multinational Entities
Reporting Requirements
Partnerships
Governmental and Not-for-Profit Entities
Corporations in Financial Difficulty
CAESARS ENTERTAINMENT CORPORATION’S DEBT TRANSFERS
An advantage when one corporation controls another is that the controlling entity’s management has the ability to transfer resources between the two legal
entities as needed. For example, the controlling corporation may make loans to, or borrow from, the other entity when cash is short. The borrower often
benefits from lower borrowing rates, less restrictive credit terms, and the informality and lower debt issue costs of intercompany borrowing relative to public
debt offerings. Additionally, the lending affiliate may benefit by being able to invest excess funds in a company about which it has considerable knowledge,
perhaps allowing it to earn a given return on the funds invested while incurring less risk than if it invested in unrelated companies. Also, the combined entity
may find it advantageous for the parent company or another affiliate to borrow funds for the entire enterprise rather than to have each affiliate go directly to
the capital markets. Intercompany indebtedness played a significant role in the resolution of the bankruptcy of Caesars Entertainment Corporation’s (CEC)
largest casino operating subsidiary, Caesars Entertainment Operating Company, Inc. (CEOC).
Between the first quarter of 2003 and the third quarter of 2007, the U.S. economy experienced especially robust economic growth. The NASDAQ, S&P
500, and the Dow Jones Industrial Average all increased by at least 60 percent; however, such unprecedented growth could not continue indefinitely. The
economic downturn of late 2007 to 2009 is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s
—the housing bubble burst, Lehman Brothers closed its doors, and the great behemoth, General Motors, was forced into bankruptcy. During this time of
economic turmoil, however, Ford was able to wisely use intercompany debt transactions to its advantage.
Caesars Entertainment is a casino entertainment and hospitality services provider and is the parent company of several subsidiaries. At 2014’s end, these
subsidiaries owned and operated or managed 49 casinos in fourteen U.S. states and five countries. However, gaming was one of the last industries to recover
from the recession of 2008-2009. While some Las Vegas properties were able to rally to a manageable degree, many of CEC’s casinos in other U.S. cities
were not so fortunate. After employing numerous market transactions designed to revive CEOC’s financial health, CEC’s management realized it was not
going to be able to save its largest subsidiary from bankruptcy. Management did, however, determine that by reorganizing some of the intercompany
indebtedness, they could soften the burden of bankruptcy for CEOC and pave the way for its brighter emergence in the future.
In August 2014, CEC directed another of its subsidiaries, Caesars Growth Partners LLC (CGP), to distribute 100 percent of its investment in CEOC
notes as a dividend to the parent company. As a result of this dividend, CEC received nearly $400 million in aggregate principal of CEOC’s senior notes,
which they then forgave. Because CGP was a consolidated entity, the CEOC notes held by CGP prior to the dividend were eliminated in consolidation. This
transfer and subsequent forgiveness of the intercompany indebtedness resulted in zero impact on CEC’s consolidated financial statements; additionally, the
transaction allowed CEOC to enter bankruptcy in the best possible financial position. On October 6, 2017, after a complicated few years in
page 375
bankruptcy court, Caesars announced CEOC’s emergence from bankruptcy, aided largely by various intercompany debt transactions such as
the one described here.
This chapter introduces accounting for debt transfers.
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO 8–1
Understand and explain concepts associated with intercompany debt transfers.
LO 8–2
Prepare journal entries and consolidation entries related to direct intercompany debt transfers.
LO 8–3
Prepare journal entries and consolidation entries related to an affiliate’s debt purchased from a nonaffiliate at an amount less than
book value.
LO 8–4
Prepare journal entries and consolidation entries related to an affiliate’s debt purchased from a nonaffiliate at an amount more than
book value.
CONSOLIDATION OVERVIEW
L O 8 –1
Understand and explain concepts associated with intercompany debt transfers.
Figure 8–1 illustrates two types of intercompany debt transfers. A direct intercompany debt transfer involves a loan from one affiliate to another without the
participation of an unrelated party, as in Figure 8–1(a). Examples include a trade receivable/payable arising from an intercompany sale of inventory on credit
and the issuance of a note payable by one affiliate to another in exchange for operating funds.
F I G U R E 8 –1
Intercompany Debt Transactions
An indirect intercompany debt transfer involves the issuance of debt to an unrelated party and the subsequent purchase of the debt instrument by an
affiliate of the issuer. For example, in Figure 8–1(b), Special Foods borrows funds by issuing a debt instrument, such as a note or a bond, to
page 376
a nonaffiliated investor. Special Foods’ parent, Peerless Products, subsequently purchased the debt instrument from the nonaffiliated investor.
Thus, Peerless Products acquires the debt of Special Foods indirectly through the nonaffiliated investor.
All account balances arising from intercorporate financing arrangements must be eliminated when consolidated statements are prepared. The consolidated
financial statements portray the consolidated entity as a single company. Therefore, in Figure 8–1, transactions that do not cross the boundary of the
consolidated entity are not reported in the consolidated financial statements. Although in illustration (a) Special Foods borrows funds from Peerless, the
consolidated entity as a whole does not borrow, and the intercompany loan is not reflected in the consolidated financial statements.
In illustration (b), Special Foods borrows funds from the nonaffiliated investor. Because this transaction is with an unrelated party and crosses the
boundary of the consolidated entity (denoted by the dashed line), it is reflected in the consolidated financial statements. In effect, the consolidated entity is
borrowing from an outside party, and the liability is included in the consolidated balance sheet. When Peerless purchases Special Foods’ debt instrument from
the nonaffiliated investor, this transaction also crosses the boundary of the consolidated entity. In effect, the consolidated entity repurchases its debt, which it
reports as a debt retirement. As with most retirements of debt before maturity, a purchase of an affiliate’s bonds usually gives rise to a gain or loss on the
retirement; the gain or loss is reported in the consolidated income statement even though it does not appear in the separate income statement of either affiliate.
This chapter discusses the procedures used to prepare consolidated financial statements when intercorporate indebtedness arises from either direct or
indirect debt transfers. Although the discussion focuses on bonds, the same concepts and procedures also apply to notes and other types of intercorporate
indebtedness.
BOND SALE DIRECTLY TO AN AFFILIATE
L O 8 –2
Prepare journal entries and consolidation entries related to direct intercompany debt transfers.
When one company sells bonds directly to an affiliate, all effects of the intercompany indebtedness must be eliminated in preparing consolidated financial
statements. A company cannot report an investment in its own bonds or a bond liability to itself. Thus, when the consolidated entity is viewed as a single
company, all amounts associated with the intercorporate indebtedness must be eliminated, including the investment in bonds, the bonds payable, any
unamortized discount or premium on the bonds, the interest income and expense on the bonds, and any accrued interest receivable and payable.
Transfer at Par Value
When a note or bond payable is sold directly to an affiliate at par value, the entries recorded by the investor and the issuer should be mirror images of each
other. To illustrate, assume that on January 1, 20X1, Special Foods borrows $100,000 from Peerless Products by issuing to Peerless $100,000 par value, 12
percent, 10-year bonds. This transaction is represented by Figure 8–1(a). During 20X1, Special Foods records interest expense on the bonds of $12,000
($100,000 × 0.12), and Peerless records an equal amount of interest income.
In the preparation of consolidated financial statements for 20X1, two consolidation entries are needed in the worksheet to remove the effects of the
intercompany indebtedness:
Eliminate Intercorporate Bond Holdings:
Bonds Payable
100,000
Investment in Special Foods Bonds
100,000
Eliminate Intercompany Interest:
Interest Income
Interest Expense
12,000
12,000
page 377
These entries eliminate from the consolidated statements the bond investment and associated income recorded on Peerless’s books and the liability and
related interest expense recorded on Special Foods’ books. The resulting statements appear as if the indebtedness does not exist, because from a consolidated
viewpoint it is not an obligation to an unaffiliated party.
Note that these entries have no effect on consolidated net income because they reduce interest income and interest expense by the same amount. These
consolidation entries are required at the end of each period for as long as the intercorporate indebtedness continues. If any interest had accrued on the bonds
at year-end, that too would have to be eliminated.
Transfer at a Discount or Premium
When the coupon or nominal interest rate on a bond is different from the yield demanded by those who lend funds, a bond sells at a discount or premium. In
these cases, the amount of bond interest income or expense recorded no longer equals the cash interest payments. Instead, interest income and expense
amounts are adjusted for the amortization of the discount or premium.
As an illustration of the treatment of intercompany bond transfers at other than par, assume that on January 1, 20X1, Peerless Products purchases
$100,000 par value, 12 percent, 10-year bonds from Special Foods when the market interest rate is 13 percent. In order to yield a 13 percent return, Special
Foods issues the bonds at a discount for $94,490.75. Interest on the bonds is payable on January 1 and July 1. The interest expense recognized by Special
Foods and the interest income recognized by Peerless each period based on effective interest amortization of the discount over the life of the bonds (straightline amortization is illustrated in Appendix A) can be summarized as follows:
Entries by the Debtor
Special Foods records the issuance of the bonds on January 1 at a discount of $5,509. It recognizes interest expense on July 1, when the first semiannual
interest payment is made, and on December 31, when interest is accrued for the second half of the year. The amortization of the bond discount page 378
causes interest expense to be higher than the cash interest payment and causes the balance of the discount to decrease. Special Foods records the
following entries related to the bonds during 20X1:1
January 1, 20X1
(1)
Cash
Discount on Bonds Payable
94,491
5,509
Bonds Payable
100,000
Issue bonds to Peerless Products.
July 1, 20X1
(2)
Interest Expense
Discount on Bonds Payable
Cash
Pay semiannual interest.
6,142
142
6,000
December 31, 20X1
(3)
Interest Expense
6,151
Discount on Bonds Payable
151
Interest Payable
6,000
Accrue interest expense at year-end.
Entries by the Bond Investor
Peerless Products records the purchase of the bonds and the interest income derived from the bonds during 20X1 with the following entries:
January 1, 20X1
(4)
Investment in Special Foods Bonds
94,491
Cash
94,491
Purchase bonds from Special Foods.
July 1, 20X1
(5)
Cash
Investment in Special Foods Bonds
6,000
142
Interest Income
6,142
Receive interest on bond investment.
December 31, 20X1
(6)
Interest Receivable
Investment in Special Foods Bonds
Interest Income
6,000
151
6,151
Accrue interest income at year-end.
The amortization of the discount by Peerless increases interest income to an amount higher than the cash interest payment and causes the balance of the
bond investment account to increase.
Consolidation Entries at Year-End 2
The December 31, 20X1, bond-related amounts taken from the books of Peerless Products and Special Foods and the appropriate consolidated amounts are
as follows:
page 379
All account balances relating to the intercorporate bond holdings must be eliminated in the preparation of consolidated financial statements. Toward that
end, the consolidation worksheet prepared on December 31, 20X1, includes the following consolidation entries related to the intercompany bond holdings:
Eliminate Intercorporate Bond Holdings:
Bonds Payable
100,000
Investment in Special Foods Bonds
94,784
Discount on Bonds Payable
5,216
Eliminate Intercompany Interest:
Interest Income
12,293
Interest Expense
12,293
Eliminate Intercompany Interest Receivable/Payable:
Interest Payable
6,000
Interest Receivable
6,000
The first entry eliminates the bonds payable and associated discount against the investment in bonds. The book value of the bond liability on Special
Foods’ books and the investment in bonds on Peerless’s books will be the same as long as both companies amortize the discount in the same way.
The second entry eliminates the bond interest income recognized by Peerless during 20X1 against the bond interest expense recognized by Special Foods.
Because the interest for the second half of 20X1 was accrued but not paid, an intercompany receivable/payable exists at the end of the year. The third entry
eliminates the interest receivable against the interest payable.
Consolidation at the end of 20X2 requires consolidation entries similar to those at the end of 20X1. Under the effective interest method, an increasing
portion of the discount is amortized each period. By the end of the second year (i.e., the fourth interest payment), the carrying value of the bond investment
on Peerless’s books increases to $95,116 ($94,491 issue price + discount amortization of $142 + $151 + $161 + 171). Similarly, the bond discount on
Special Foods’ books decreases to $4,884, resulting in an effective bond liability of $95,116. The consolidation entries related to the bonds at the end of 20X2
are as follows:
Eliminate Intercorporate Bond Holdings:
Bonds Payable
100,000
Investment in Special Foods Bonds
95,116
Discount on Bonds Payable
4,884
Eliminate Intercompany Interest:
Interest Income
12,332
Interest Expense
12,332
Eliminate Intercompany Interest Receivable/Payable:
Interest Payable
Interest Receivable
6,000
6,000
BONDS OF AFFILIATE PURCHASED FROM A NONAFFILIATE
A more complex situation occurs when an affiliate of the issuer later acquires bonds that were issued to an unrelated party. From the viewpoint of the
consolidated entity, an acquisition of an affiliate’s bonds retires the bonds at the time they are purchased. The bonds no longer are held outside the page 380
consolidated entity once another company within the consolidated entity purchases them, and they must be treated as if repurchased by the
debtor. Acquisition of an affiliate’s bonds by another company within the consolidated entity is referred to as constructive retirement. Although the bonds
actually are not retired, they are treated as if they were retired in preparing consolidated financial statements.
When a constructive retirement occurs, the consolidated income statement for the period reports a gain or loss on debt retirement based on the difference
between the carrying value of the bonds on the books of the debtor and the purchase price paid by the affiliate in acquiring the bonds. Neither the bonds
payable nor the purchaser’s investment in the bonds is reported in the consolidated balance sheet because the bonds are no longer considered outstanding.
Purchase at Book Value
In the event that a company purchases an affiliate’s debt from an unrelated party at a price equal to the liability reported by the debtor, the consolidation
entries required in preparing the consolidated financial statements are identical to those used in eliminating a direct intercorporate debt transfer. In this case,
the total of the bond liability and the related premium or discount reported by the debtor equal the balance in the investment account shown by the
bondholder, and the interest income reported by the bondholder each period equals the interest expense reported by the debtor. All these amounts need to be
eliminated to avoid misstating the accounts in the consolidated financial statements.
Purchase at an Amount Less than Book Value
L O 8 –3
Prepare journal entries and consolidation entries related to an affiliate’s debt purchased from a nonaffiliate at an amount less than book
value.
Continuing movement in the level of interest rates and the volatility of other factors influencing the securities markets make it unlikely that a company’s
bonds will sell after issuance at a price identical to their book value. When the price paid to acquire an affiliate’s bonds differs from the liability reported by
the debtor, a gain or loss is reported in the consolidated income statement in the period of constructive retirement. In addition, the bond interest income and
interest expense reported by the two affiliates subsequent to the purchase must be eliminated in preparing consolidated statements. Interest income reported
by the investing affiliate and interest expense reported by the debtor are not equal in this case because of the different bond carrying amounts on the books of
the two companies. The difference in the bond carrying amounts is reflected in the amortization of the discount or premium and, in turn, causes interest
income and expense to differ.
As an example of consolidation following the purchase of an affiliate’s bonds at less than book value, assume that Peerless Products Corporation
purchases 80 percent of the common stock of Special Foods Inc. on December 31, 20X0, for its underlying book value of $240,000. At that date, the fair
value of the noncontrolling interest is equal to its book value of $60,000. In addition, the following conditions occur:
1. On January 1, 20X1, Special Foods issues 10-year, 12 percent bonds payable with a par value of $100,000; the bonds are issued at a premium, $105,975.19, to yield
the current market interest rate of 11 percent. A nonaffiliated investor purchases the bonds from Special Foods.
2. The bonds pay interest on June 30 and December 31.
3. Both Peerless Products and Special Foods amortize bond discounts and premiums using the effective interest method.
4. On December 31, 20X1, Peerless Products purchases the bonds from the nonaffiliated investor for $94,823.04 when the bonds’ carrying value on Special Foods’
books is $105,623.04, resulting in a gain of $10,800 on the constructive retirement of the bonds. Note that Peerless’s purchase price reflects the current market
interest rate of 12.992186% when the bonds have 18 payments left to maturity.
5. Special Foods reports net income of $50,152 for 20X1 and $75,192 for 20X2 and declares dividends of $30,000 in 20X1 and $40,000 in 20X2.
page 381
6. Peerless earns $140,000 in 20X1 and $160,000 in 20X2 from its own separate operations. Peerless declares dividends of $60,000 in both 20X1 and 20X2.
The bond transactions of Special Foods and Peerless appear as follows:
In addition, the interest expense recognized by Special Foods each period based on effective interest amortization of the premium over the life of the bonds
can be summarized as follows:
page 382
Bond Liability Entries—20X1
Special Foods records the following entries related to its bonds during 20X1:
January 1, 20X1
(7)
Cash
105,975
Bonds Payable
100,000
Premium on Bonds Payable
5,975
Sale of bonds to nonaffiliated investor.
June 30, 20X1
(8)
Interest Expense
Premium on Bonds Payable
5,829
171
Cash
6,000
Semiannual payment of interest (see amortization table).
December 31, 20X1
(9)
Interest Expense
Premium on Bonds Payable
Cash
5,819
181
6,000
Semiannual payment of interest.
Entry (7) records the issuance of the bonds to a nonaffiliated investor for $105,975. Entries (8) and (9) record the payment of interest and the amortization
of the bond premium at each of the two interest payment dates during 20X1. Total interest expense for 20X1 is $11,648 ($5,829 + $5,819), and the book
value of the bonds on December 31, 20X1, is $105,623 as shown in the amortization table.
Bond Investment Entries—20X1
Peerless Products records the purchase of Special Foods’ bonds from the nonaffiliated party with the following entry:
December 31, 20X1
(10)
Investment in Special Foods Bonds
94,823
Cash
94,823
Purchase of Special Foods bonds from a nonaffiliated investor.
This entry is the same as if the bonds purchased were those of an unrelated company. Peerless purchases the bonds at the very end of the year after payment
of the interest to the nonaffiliated investor; therefore, Peerless earns no interest on the bonds during 20X1, nor is there any interest accrued on the bonds at
the date of purchase.
Computation of Gain on Constructive Retirement of Bonds
From a consolidated viewpoint, the purchase of Special Foods’ bonds by Peerless is considered a retirement of the bonds by the consolidated entity.
Therefore, in the preparation of consolidated financial statements, a gain or loss must be recognized for the difference between the book value of the bonds
on the date of repurchase and the amount paid by the consolidated entity in reacquiring the bonds:
Book value of Special Foods’ bonds, December 31, 20X1
$105,623
Price paid by Peerless to purchase bonds
(94,823)
Gain on constructive retirement of bonds
$ 10,800
This gain is included in the consolidated income statement as a gain on the retirement of bonds.
Assignment of Gain on Constructive Retirement
Four approaches have been used in practice for assigning the gain or loss on the constructive retirement of an affiliate’s bonds to the shareholders of the
participating companies. Depending upon the method selected, the gain or loss may be assigned to any of the following:
page 383
1. The affiliate issuing the bonds.
2. The affiliate purchasing the bonds.
3. The parent company.
4. The issuing and purchasing companies based on the difference between the carrying amounts of the bonds on their books at the date of purchase and the par
value of the bonds.
No compelling reasons seem to exist for choosing one of these methods over the others, and in practice the choice often is based on expediency and lack
of materiality. The FASB’s approach is to assign the gain or loss to the issuing company (approach 1). In previous chapters, gains and losses on
intercompany transactions were viewed as accruing to the shareholders of the selling affiliate. When this approach is applied in the case of intercorporate
debt transactions, gains and losses arising from the intercompany debt transactions are viewed as accruing to the shareholders of the selling or issuing
affiliate. In effect, the purchasing affiliate is viewed as acting on behalf of the issuing affiliate by acquiring the bonds.
An important difference exists between the intercompany gains and losses discussed in previous chapters and the gains and losses arising from
intercorporate debt transactions. Gains and losses from intercorporate transfers of assets are recognized by the individual affiliates and are eliminated in
consolidation. Gains and losses from intercorporate debt transactions are not recognized by the individual affiliates but must be included in consolidation.
When the subsidiary is the issuing affiliate, the gain or loss on constructive retirement of the bonds is viewed as accruing to the subsidiary’s shareholders.
Thus, the gain or loss is apportioned between the controlling and noncontrolling interests based on the relative ownership interests in the common stock
(similar to upstream inventory or asset transfers). If the parent is the issuing affiliate, the entire gain or loss on the constructive retirement accrues to the
controlling interest and none is apportioned to the noncontrolling interest (similar to downstream inventory or asset transfers).
As a result of the interest income and expense entries recorded annually by the companies involved, the constructive gain or loss is recognized over the
remaining term of the bond issue; accordingly, the total amount of the unrecognized gain or loss decreases each period and is fully amortized at the time the
bond matures. Thus, no permanent gain or loss is assigned to the debtor company’s shareholders.
Fully Adjusted Equity-Method Entries—20X1
In addition to recording the bond investment with entry (10), Peerless records the following equity-method entries during 20X1 to account for its investment
in Special Foods stock:
(11)
Investment in Special Foods Stock
Income from Special Foods
40,122
40,122
Record equity-method income: $50,152 × 0.80.
(12)
Cash
24,000
Investment in Special Foods Stock
24,000
Record dividends from Special Foods: $30,000 × 0.80.
The full gain on constructive retirement is included in consolidated net income. That gain is attributed to the shareholders of the issuing company, Special
Foods. Therefore, Peerless records its proportionate share of the gain, $8,640 ($10,800 × 0.80), under the fully adjusted equity method.
(13) Investment in Special Foods
8,640
Income from Special Foods
8,640
Record Peerless’s 80% share of the gain on the constructive retirement of Special Foods’ bonds.
page 384
We note that a proportionate share of the gain is also assigned to the noncontrolling interest when the consolidation entries are made in preparing the
worksheet. If Peerless had been the issuing affiliate, all of the gain would have been included in its share of consolidated net income and none would have
been allocated to the noncontrolling interest. These entries result in a $264,762 balance in the investment account at the end of 20X1.
Consolidation Worksheet—20X1
Figure 8–2 illustrates the consolidation worksheet prepared at the end of 20X1. The first two consolidation entries are the same as we prepared in Chapter 3
with one minor exception. Although the analysis of the book value portion of the investment account is the same, in preparing the basic consolidation entry,
we increase the amounts in Peerless’s Income from Special Foods and Investment in Special Foods accounts by Peerless’s share of the gain on bond
retirement, $8,640 ($10,800 × 80%). We also increase the NCI in Net Income of Special Foods and NCI in Net Assets of Special Foods accounts by the
NCI share of the gain, $2,160 ($10,800 × 20%).
page 385
F I G U R E 8 –2
December 31, 20X1, Consolidation Worksheet; Repurchase of Bonds at Less than Book Value
Special Foods’ bonds payable and Peerless’s investment in Special Foods’ bonds cannot appear in the consolidated balance sheet because the bond
holdings involve parties totally within the single economic entity. Note that the gain recognized on the constructive retirement of the bonds does not appear on
the books of either Peerless or Special Foods because the bonds are still outstanding from the perspective of the separate companies. From the viewpoint of
the consolidated entity, the bonds are retired at the end of 20X1, and a gain must be entered in the consolidation worksheet so that it appears in the
consolidated income statement.
page 386
Thus, the consolidation worksheet entry to eliminate intercompany bond holdings eliminates the bond payable and its associated premium accounts from
Special Foods’ financial statements. It also removes the investment in Special Foods Bonds from Peerless’s financial statements. Finally, it records the bond
retirement gain.
Eliminate Intercorporate Bond Holdings:
Bonds Payable
Premium on Bonds Payable
100,000
5,623
Investment in Special Foods Bonds
94,823
Gain on Bond Retirement
10,800
No consolidations are needed with respect to interest income or interest expense in preparing the consolidated statements for December 31, 20X1.
Because Peerless purchased the bonds at the end of the year, Peerless records no interest income until 20X2. The interest expense of $11,648 ($5,829 +
5,819) recorded by Special Foods is viewed appropriately as interest expense of the consolidated entity because an unrelated party held the bonds during all
of 20X1.
Consolidated Net Income—20X1
Consolidated net income of $200,952 (Figure 8–2) is computed and allocated as follows:
Peerless’s separate income
Special Foods’ net income
Gain on constructive retirement of bonds
$140,000
$50,152
10,800
Special Foods’ realized net income
60,952
Consolidated net income, 20X1
$200,952
Income to noncontrolling interest ($60,952 × 0.20)
(12,190)
Income to controlling interest
$188,762
Consolidated net income is $10,800 higher than it would have been had Peerless not purchased the bonds.
Noncontrolling Interest—December 31, 20X1
Total noncontrolling interest on December 31, 20X1, in the absence of a differential, includes a proportionate share of both the reported book value of Special
Foods and the gain on constructive bond retirement. The balance of the noncontrolling interest on December 31, 20X1, is computed as follows:
Book value of Special Foods’ net assets, December 31, 20X1:
Common stock
$ 200,000
Retained earnings
Total reported book value
120,152
$ 320,152
Gain on constructive retirement of bonds
Realized book value of Special Foods’ net assets
10,800
$ 330,952
Noncontrolling stockholders’ share
Noncontrolling interest in net assets December 31, 20X1
×0.20
$
66,190
page 387
Bond Liability Entries—20X2
Special Foods records interest on its bonds during 20X2 with the following entries:
June 30, 20X2
(14)
Interest Expense
5,809
Premium on Bonds Payable
191
Cash
6,000
Semiannual payment of interest.
December 31, 20X2
(15)
Interest Expense
5,799
Premium on Bonds Payable
201
Cash
6,000
Semiannual payment of interest.
Bond Investment Entries—20X2
Peerless Products accounts for its investment in Special Foods’ bonds in the same way as if the bonds were those of a nonaffiliate. The $94,823 purchase
price paid by Peerless reflects a $5,177 ($100,000 − $94,823) discount from the par value of the bonds. This discount is amortized over the nine-year
remaining term of the bonds based on the amortization table (partially presented below) for each six-month interest payment period.
Peerless’s entries to record interest income for 20X2 are as follows:
June 30, 20X2
(16)
Cash
6,000
Investment in Special Foods Bonds
160
Interest Income
6,160
Record receipt of bond interest.
December 31, 20X2
(17)
Cash
6,000
Investment in Special Foods Bonds
Interest Income
Record receipt of bond interest.
Peerless earns this $12,330 ($6,160 + $6,170) of interest income in addition to its $160,000 of separate operating income for 20X2.
Subsequent Recognition of Gain on Constructive Retirement
170
6,170
In the year of the constructive bond retirement, 20X1, the entire $10,800 gain on the retirement is recognized in the consolidated income statement but not
on the books of either Peerless or Special Foods. The total gain on the constructive bond retirement in 20X1 is equal to the sum of Peerless’s page 388
discount on the bond investment and Special Foods’ premium on the bond liability at the time of the constructive retirement (12/31/20X1).
Peerless’s discount on bond investment
Special Foods’ premium on bond liability
$ 5,177
5,623
Total gain on constructive retirement of bonds $10,800
This concept can be illustrated as follows:
In each year subsequent to 20X1, both Peerless and Special Foods recognize a portion of the constructive gain as they amortize the discount on the bond
investment and the premium on the bond liability (based on their respective amortization tables). Thus, the $10,800 gain on constructive bond retirement,
previously recognized in the consolidated income statement, is recognized on the books of Peerless and Special Foods over the remaining nine-year term of
the bonds.
Fully Adjusted Equity-Method Entries—20X2
Peerless recognizes its share of Special Foods’ income ($75,192) and dividends ($40,000) for 20X2 with the normal equity-method entries:
(18)
Investment in Special Foods
60,154
Income from Special Foods
60,154
Record Peerless’s 80% share of Special Foods’ 20X2 income.
(19)
Cash
32,000
Investment in Special Foods
Record Peerless’s 80% share of Special Foods’ 20X2 dividend.
Under the fully adjusted equity method, Peerless records its proportionate 80 percent share of the constructive gain recognition.
32,000
(20)
Income from Special Foods
578
Investment in Special Foods
578
Recognize 80% share of amortization of premium and discount [0.80 × (191 + 201 + 160 + 170)].
Whereas neither Peerless nor Special Foods recognized any of the gain from the constructive bond retirement on its separate books in 20X1, Peerless
adjusted its equity-method income from Special Foods for its 80 percent share of the $10,800 gain, $8,640. Therefore, as Peerless and Special page 389
Foods recognize the gain over the remaining term of the bonds, Peerless must reverse its 20X1 entry for its share of the gain. This adjustment is
needed to avoid double-counting Peerless’s share of the gain. Thus, the original adjustment of $8,640 is reversed by the 80 percent portion of the combined
amortization of Special Foods’ premium and Peerless’s discount each year.
Consolidation Worksheet—20X2
Figure 8–3 presents the consolidation worksheet for December 31, 20X2. The first two consolidation entries are the same as we prepared in Chapter 3 with
the previously explained exception. Although the analysis of the book value portion of the investment account is the same, in preparing the basic consolidation
entry, a portion of the constructive gain is recognized and shared between Peerless (80 percent) and the NCI shareholders (20 percent). Thus, the basic
consolidation entry subtracts the proportionate share of the constructive gain recognition from the Income from Special Foods, Investment in Special Foods’
stock, NCI in net income of Special Foods, and NCI in net assets of Special Foods accounts.
F I G U R E 8 –3
December 31, 20X2, Consolidation Worksheet; Next Year Following Repurchase of Bonds at Less than Book Value
page 390
The worksheet entry to eliminate the intercompany bond holdings credits the constructive gain on the bond retirement amount between the NCI interest
in net assets of Special Foods and Peerless’s Investment in Special Foods Common Stock account. In other words, the worksheet entry credits the
Investment in Special Foods Common Stock account for $8,640 ($10,800 × 0.80) to eliminate the remaining balance in the account. Similarly, the
noncontrolling interest is increased by $2,160 ($10,800 × 0.20), its proportionate share of the constructive gain on the bond retirement.
The intercompany bond holdings consolidation entry also eliminates all aspects of the intercorporate bond holdings, including (1) Peerless’s investment in
bonds, $95,153, (2) Special Foods’ bonds payable, $100,000, and the associated premium, $5,231, (3) Peerless’s bond interest income, $12,330, and (4)
Special Foods’ bond interest expense, $11,608 ($5,809 + $5,799). The amounts related to the bonds from the books of Peerless and Special Foods and the
appropriate consolidated amounts are as follows:
page 391
This analysis leads to the following worksheet entry to eliminate intercompany bond holdings:
Eliminate Intercompany Bond Holdings:
Bonds Payable
100,000
Premium on Bonds Payable
Interest Income
5,231
12,330
Investment in Special Foods Bonds
95,153
Interest Expense
11,608
Investment in Special Foods Stock
8,640
NCI in NA of Special Foods
2,160
Investment Account—20X2
The following T-accounts illustrate Peerless’s Investment in the common stock of Special Foods and Income from Special Foods accounts at the end of
20X2 and how the consolidation entries zero out their balances on the worksheet:
Consolidated Net Income—20X2
Consolidated net income of $246,800 in Figure 8–3 is computed and allocated as follows:
Peerless’s separate income
Special Foods’ net income
$172,330
$75,192
Peerless’s amortization of bond discount
(330)
Special Foods’ amortization of bond premium
(392)
Special Foods’ realized net income
74,470
Consolidated net income, 20X1
$246,800
Income to noncontrolling interest ($74,470 × 0.20)
(14,894)
Income to controlling interest
$231,906
Noncontrolling Interest—December 31, 20X2
Total noncontrolling interest in the Net Assets of Special Foods account on December 31, 20X2, includes a proportionate share of both the reported book
value of Special Foods and the portion of the gain on constructive bond retirement not yet recognized by the affiliates:
Book value of Special Foods’ net assets, December 31, 20X2:
Common stock
$200,000
Retained earnings
155,344
Total book value of net assets
Gain on constructive retirement of bonds
Less: Portion recognized by affiliates during 20X2
Constructive gain not yet recognized by affiliates
Realized book value of Special Foods net assets
$355,344
$10,800
(722)
10,078
$365,422
Noncontrolling stockholders’ share
×0.20
Noncontrolling interest in net assets, December 31, 20X2
$ 73,084
page 392
Bond Consolidation Entry in Subsequent Years
In years after 20X2, the worksheet entry to eliminate the intercompany bonds and to adjust for the gain on constructive retirement of the bonds is similar to
the entry to eliminate intercompany bond holdings in 20X2. The unamortized bond discount and premium decrease each year based on the amortization table.
As of the beginning of 20X3, $10,078 of the gain on the constructive retirement of the bonds remains unrecognized by the affiliates, computed as follows:
Gain on constructive retirement of bonds
$10,800
Less: Portion recognized by affiliates during 20X2:
Peerless’s amortization of bond discount
$330
Special Foods’ amortization of bond premium
392
Total gain recognized by affiliates
(722)
Unrecognized gain on constructive retirement of bonds, January 1, 20X3
$10,078
The remaining unrecognized gain, $10,078, can be allocated between Peerless ($8,062) and the noncontrolling interest ($2,016) based on their respective
ownership interests (80% and 20%). The intercompany bond holdings consolidation entry also eliminates all aspects of the intercorporate bond holdings,
including (1) Peerless’s investment in bonds, $95,527, (2) Special Foods’ bonds payable, $100,000, and the associated premium, $4,795, (3) Peerless’s bond
interest income, $12,374, and (4) Special Foods’ bond interest expense, $11,564 ($5,788 + $5,776). The amounts related to the bonds from the books of
Peerless and Special Foods and the appropriate consolidated amounts are as follows:
Based on these numbers, the bond consolidation entry at the end of 20X3 would be as follows:
Eliminate Intercompany Bond Holdings:
Bonds Payable
Premium on Bonds Payable
Interest Income
100,000
4,795
12,374
Investment in Special Foods Bonds
95,527
Interest Expense
11,564
Investment in Special Foods Stock
8,062
NCI in NA of Special Foods
2,016
Purchase at an Amount Higher than Book Value
L O 8 –4
Prepare journal entries and consolidation entries related to an affiliate’s debt purchased from a nonaffiliate at an amount more than book
value.
When an affiliate’s bonds are purchased from a nonaffiliate at an amount greater than their book value, the consolidation procedures are virtually the same as
previously illustrated except that a loss is recognized on the constructive retirement of the debt. For example, assume that Special Foods issues 10-year, 12
percent bonds on January 1, 20X1, at par of $100,000. The bonds are purchased from Special Foods by a nonaffiliate, which sells the bonds to Peerless
Products on December 31, 20X1, for $104,500.
page 393
The bond transactions of Special Foods and Peerless appear as follows:
Special Foods recognizes $12,000 ($100,000 × 0.12) of interest expense each year. Peerless recognizes interest income based on the following amortization
table:
Because the bonds were issued at par, the carrying amount on Special Foods’ books remains at $100,000. Thus, once Peerless purchases the bonds from a
nonaffiliate for $104,500, a loss on the constructive retirement must be recognized in the consolidated income statement for $4,500 ($104,500–$100,000).
The bond consolidation entry in the worksheet prepared at the end of 20X1 removes the bonds payable and the bond investment and recognizes the loss on
the constructive retirement:
Eliminate Intercorporate Bond Holdings:
Bonds Payable
Loss on Bond Retirement
Investment in Special Foods Bonds
100,000
4,500
104,500
In subsequent years, Peerless amortizes the premium on the bond investment, reducing interest income and the bond investment balance by the amount the
premium is amortized each year. This, in effect, recognizes a portion of the loss on the constructive retirement. When consolidated statements are prepared,
the amount of the loss on constructive retirement that has not been recognized by the separate affiliates at the beginning of the period is allocated
proportionately against the ownership interests of the issuing affiliate. The bond consolidation entry needed in the worksheet prepared at the end page 394
of 20X2 is as follows:
Eliminate Intercompany Bond Holdings:
Bonds Payable
100,000
Interest Income
11,689
Investment in Special Foods Stock
3,600
NCI in NA of Special Foods
900
Investment in Special Foods Bonds
104,189
Interest Expense
12,000
Similarly, the following worksheet entry is needed in the consolidation worksheet at the end of 20X3:
Eliminate Intercompany Bond Holdings:
Bonds Payable
Interest Income
Investment in Special Foods Stock
NCI in NA of Special Foods
100,000
11,653
3,351
838
Investment in Special Foods Bonds
Interest Expense
103,842
12,000
SUMMARY OF KEY CONCEPTS
The effects of intercompany debt transactions must be eliminated completely in preparing consolidated financial statements, just as with other types of
intercompany transactions. Only debt transactions between the consolidated entity and unaffiliated parties are reported in the consolidated statements.
When one affiliate issues bonds that are purchased directly by another affiliate, the bonds are viewed from a consolidated point of view as never having been
issued. Thus, all aspects of the intercompany bond holding are eliminated in consolidation. Items requiring consolidation include (1) the bond investment from the
purchasing affiliate’s books, (2) the bond liability and any associated discount or premium from the issuer’s books, (3) the interest income recognized by the
investing affiliate and the interest expense recognized by the issuer, and (4) any intercompany interest receivable/payable as of the date of the consolidated
statements.
When a company purchases the bonds of an affiliate from a nonaffiliate, it treats the bonds in consolidation as if they had been issued and subsequently
repurchased by the consolidated entity. If the price paid by the purchasing affiliate is different from the issuer’s book value of the bonds, a gain or loss from
retirement of the bonds is recognized in the consolidated income statement. In addition, all aspects of the intercompany bond holding are eliminated because the
bonds are treated as if the consolidated entity had retired them.
page 395
KEY TERMS
constructive retirement, 380
direct intercompany debt transfer, 375
indirect intercompany debt transfer, 375
Appendix 8A
Intercompany Indebtedness—Fully
Adjusted Equity Method Using StraightLine Interest Amortization
L O 8 –2
Prepare journal entries and consolidation entries related to direct intercompany debt transfers.
This appendix repeats the main examples in the chapter but assumes that the companies amortize interest using the straight-line method for amortizing discounts
and premiums on bonds payable.
TRANSFER AT A DISCOUNT OR PREMIUM
When the coupon or nominal interest rate on a bond is different from the yield demanded by those who lend funds, a bond sells at a discount or premium. In such
cases, the amount of bond interest income or expense recorded no longer equals the cash interest payments. Instead, interest income and expense amounts are
adjusted for the amortization of the discount or premium.
As an illustration of the treatment of intercompany bond transfers at other than par, assume that on January 1, 20X1, Peerless Products purchases $100,000 par
value, 12 percent, 10-year bonds from Special Foods for $90,000. Interest on the bonds is payable on January 1 and July 1. The interest expense recognized by
Special Foods and the interest income recognized by Peerless each year include straight-line amortization of the discount, as follows:
Cash interest ($100,000 × 0.12)
Amortization of discount ($10,000 ÷ 20 semiannual interest periods) × 2 periods
Interest expense or income
$12,000
1,000
$13,000
Half of these amounts are recognized in each of the two interest payment periods during a year. Although the effective interest method of amortization usually is
required for amortizing discounts and premiums, the straight-line method is acceptable when it does not depart materially from the effective interest method and
when transactions are between parent and subsidiary companies or between subsidiaries of a common parent.
Entries by the Debtor
Special Foods records the issuance of the bonds on January 1 at a discount of $10,000. It recognizes interest expense on July 1 when the first semiannual interest
payment is made, and on December 31, when interest is accrued for the second half of the year. The amortization of the bond discount causes interest expense to be
higher than the cash interest payment and causes the balance of the discount to decrease. Special Foods records the following entries related to the bonds during
20X1:
January 1, 20X1
(1A)
Cash
90,000
Discount on Bonds Payable
10,000
Bonds Payable
100,000
Issue bonds to Peerless Products.
July 1, 20X1
(2A)
Interest Expense
6,500
Discount on Bonds Payable
500
Cash
6,000
Make semiannual interest payment.
December 31, 20X1
(3A)
Interest Expense
6,500
Discount on Bonds Payable
500
Interest Payable
6,000
Accrue interest expense at year-end.
page 396
Entries by the Bond Investor
Peerless Products records the purchase of the bonds and the interest income derived from the bonds during 20X1 with the following entries:
January 1, 20X1
(4A)
Investment in Special Foods Bonds
90,000
Cash
90,000
Purchase bonds from Special Foods.
July 1, 20X1
(5A)
Cash
6,000
Investment in Special Foods Bonds
500
Interest Income
6,500
Receive interest on bond investment.
December 31, 20X1
(6A)
Interest Receivable
6,000
Investment in Special Foods Bonds
500
Interest Income
6,500
Accrue interest income at year-end.
The amortization of the discount by Peerless increases interest income to an amount higher than the cash interest payment and causes the balance of the bond
investment account to increase.
Consolidation Entries at Year-End
The December 31, 20X1, bond-related amounts taken from the books of Peerless Products and Special Foods and the appropriate consolidated amounts are as
follows:
All account balances relating to the intercorporate bond holdings must be eliminated in the preparation of consolidated financial statements. Toward that end,
the consolidation worksheet prepared on December 31, 20X1, includes the following consolidation entries related to the intercompany bond holdings:
Eliminate Intercorporate Bond Holdings:
Bonds Payable
100,000
Investment in Special Foods Bonds
91,000
Discount on Bonds Payable
9,000
Eliminate Intercompany Interest:
Interest Income
13,000
Interest Expense
13,000
Eliminate Intercompany Interest Receivable/Payable:
Interest Payable
6,000
Interest Receivable
6,000
The first entry eliminates the bonds payable and associated discount against the investment in bonds. The book value of the bond liability on Special Foods’ books
and the investment in bonds on Peerless’s books will be the same as long as both companies amortize the discount in the same way.
page 397
The second entry eliminates the bond interest income recognized by Peerless during 20X1 against the bond interest expense recognized by Special Foods.
Because the interest for the second half of 20X1 was accrued but not paid, an intercompany receivable/payable exists at the end of the year. The third entry
eliminates the interest receivable against the interest payable.
Consolidation at the end of 20X2 requires consolidation entries similar to those at the end of 20X1. Because $1,000 of the discount is amortized each year, the
bond investment balance on Peerless’s books increases to $92,000 ($90,000 + $1,000 + $1,000). Similarly, the bond discount on Special Foods’ books decreases to
$8,000, resulting in an effective bond liability of $92,000. The consolidation entries related to the bonds at the end of 20X2 are as follows:
Eliminate Intercorporate Bond Holdings:
Bonds Payable
100,000
Investment in Special Foods Bonds
92,000
Discount on Bonds Payable
8,000
Eliminate Intercompany Interest:
Interest Income
13,000
Interest Expense
13,000
Eliminate Intercompany Interest Receivable/Payable:
Interest Payable
6,000
Interest Receivable
6,000
BONDS OF AFFILIATE PURCHASED FROM A NONAFFILIATE
A more complex situation occurs when an affiliate of the issuer later acquires bonds that were issued to an unrelated party. From the viewpoint of the consolidated
entity, an acquisition of an affiliate’s bonds retires the bonds at the time they are purchased. The bonds no longer are held outside the consolidated entity once
another company within the consolidated entity purchases them, and they must be treated as if repurchased by the debtor. Acquisition of an affiliate’s bonds by
another company within the consolidated entity is referred to as constructive retirement. Although the bonds actually are not retired, they are treated as if they
were retired in preparing consolidated financial statements.
When a constructive retirement occurs, the consolidated income statement for the period reports a gain or loss on debt retirement based on the difference
between the carrying value of the bonds on the books of the debtor and the purchase price paid by the affiliate in acquiring the bonds. Neither the bonds payable
nor the purchaser’s investment in the bonds is reported in the consolidated balance sheet because the bonds are no longer considered outstanding.
Purchase at Book Value
In the event that a company purchases an affiliate’s debt from an unrelated party at a price equal to the liability reported by the debtor, the consolidation entries
required in preparing the consolidated financial statements are identical to those used in eliminating a direct intercorporate debt transfer. In this case, the total of the
bond liability and the related premium or discount reported by the debtor equal the balance in the investment account shown by the bondholder, and the interest
income reported by the bondholder each period equals the interest expense reported by the debtor. All of these amounts need to be eliminated to avoid misstating
the accounts in the consolidated financial statements.
Purchase at an Amount Less than Book Value
L O 8 –3
Prepare journal entries and consolidation entries related to an affiliate’s debt purchased from a nonaffiliate at an amount less than book
value.
Continuing movement in the level of interest rates and the volatility of other factors influencing the securities markets make it unlikely that a company’s bonds will
sell after issuance at a price identical to their book value. When the price paid to acquire an affiliate’s bonds differs from the liability reported by the debtor, a gain or
loss is reported in the consolidated income statement in the period of constructive retirement. In addition, the bond interest income and interest expense reported by
the two affiliates subsequent to the purchase must be eliminated in preparing consolidated statements. Interest income reported by the investing affiliate and
interest expense reported by the debtor are not equal in this case because of the different bond carrying amounts on the books of the two companies. The
difference in the bond carrying amounts is reflected in the amortization of the discount or premium and, in turn, causes interest income and expense to page 398
differ.
As an example of consolidation following the purchase of an affiliate’s bonds at less than book value, assume that Peerless Products Corporation purchases 80
percent of the common stock of Special Foods Inc. on December 31, 20X0, for its underlying book value of $240,000. At that date, the fair value of the
noncontrolling interest is equal to its book value of $60,000. In addition, the following conditions occur:
1. On January 1, 20X1, Special Foods issues 10-year, 12 percent bonds payable with a par value of $100,000; the bonds are issued at 102. The nonaffiliated
investor purchases the bonds from Special Foods.
2. The bonds pay interest on June 30 and December 31.
3. Both Peerless Products and Special Foods amortize bond discount and premium using the straight-line method.
4. On December 31, 20X1, Peerless Products purchases the bonds from the nonaffiliated investor for $91,000.
5. Special Foods reports net income of $50,000 for 20X1 and $75,000 for 20X2 and declares dividends of $30,000 in 20X1 and $40,000 in 20X2.
6. Peerless earns $140,000 in 20X1 and $160,000 in 20X2 from its own separate operations. Peerless declares dividends of $60,000 in both 20X1 and 20X2.
The bond transactions of Special Foods and Peerless appear as follows:
Bond Liability Entries—20X1
Special Foods records the following entries related to its bonds during 20X1:
January 1, 20X1
(7A)
Cash
Bonds Payable
Premium on Bonds Payable
Sale of bonds to the nonaffiliated investor.
June 30, 20X1
102,000
100,000
2,000
(8A)
Interest Expense
5,900
Premium on Bonds Payable
100
Cash
6,000
Semiannual payment of interest:
$5,900 = $6,000 − $100
$100 = $2,000 ÷ 20 interest periods
$6,000 = $100,000 × 0.12 × 6/12.
page 399
December 31, 20X1
(9A)
Interest Expense
5,900
Premium on Bonds Payable
100
Cash
6,000
Semiannual payment of interest.
Entry (7A) records the issuance of the bonds to the nonaffiliated investor for $102,000. Entries (8A) and (9A) record the payment of interest and the amortization of
the bond premium at each of the two interest payment dates during 20X1. Total interest expense for 20X1 is $11,800 ($5,900 × 2), and the book value of the bonds on
December 31, 20X1, is as follows:
Book value of bonds at issuance
$102,000
Amortization of premium, 20X1
(200)
Book value of bonds, December 31, 20X1 $101,800
Bond Investment Entries—20X1
Peerless Products records the purchase of Special Foods’ bonds from the nonaffiliated investor with the following entry:
December 31, 20X1
(10A)
Investment in Special Foods Bonds
91,000
Cash
91,000
Purchase of Special Foods bonds from a nonaffiliated investor.
This entry is the same as if the bonds purchased were those of an unrelated company. Peerless purchases the bonds at the very end of the year after payment of the
interest to a nonaffiliated investor; therefore, Peerless earns no interest on the bonds during 20X1, nor is there any interest accrued on the bonds at the date of
purchase.
Computation of Gain on Constructive Retirement of Bonds
From a consolidated viewpoint, the purchase of Special Foods’ bonds by Peerless is considered a retirement of the bonds by the consolidated entity. Therefore, in
the preparation of consolidated financial statements, a gain or loss must be recognized for the difference between the book value of the bonds on the date of
repurchase and the amount paid by the consolidated entity in reacquiring the bonds:
Book value of Special Foods’ bonds, December 31, 20X1
$101,800
Price paid by Peerless to purchase bonds
Gain on constructive retirement of bonds
(91,000)
$
10,800
This gain is included in the consolidated income statement as a gain on the retirement of bonds.
Assignment of Gain on Constructive Retirement
Four approaches have been used in practice for assigning the gain or loss on the constructive retirement of an affiliate’s bonds to the shareholders of the
participating companies. Depending upon the method selected, the gain or loss may be assigned to any of the following:
1. The affiliate issuing the bonds.
2. The affiliate purchasing the bonds.
3. The parent company.
4. The issuing and purchasing companies based on the difference between the carrying amounts of the bonds on their books at the date of purchase and the par
value of the bonds.
No compelling reasons seem to exist for choosing one of these methods over the others, and in practice, the choice often is based on expediency and lack of
materiality. The FASB’s approach is to assign the gain or loss to the issuing company. In previous chapters, gains and losses on intercompany
page 400
transactions were viewed as accruing to the shareholders of the selling affiliate. When this approach is applied in the case of intercorporate debt
transactions, gains and losses arising from the intercompany debt transactions are viewed as accruing to the shareholders of the selling or issuing affiliate. In effect,
the purchasing affiliate is viewed as acting on behalf of the issuing affiliate by acquiring the bonds.
An important difference exists between the intercompany gains and losses discussed in previous chapters and the gains and losses arising from intercorporate
debt transactions. Gains and losses from intercorporate transfers of assets are recognized by the individual affiliates and are eliminated in consolidation. Gains and
losses from intercorporate debt transactions are not recognized by the individual affiliates but must be included in consolidation.
When the subsidiary is the issuing affiliate, the gain or loss on constructive retirement of the bonds is viewed as accruing to the subsidiary’s shareholders.
Thus, the gain or loss is apportioned between the controlling and noncontrolling interests based on the relative ownership interests in the common stock (similar to
upstream inventory or asset transfers). If the parent is the issuing affiliate, the entire gain or loss on the constructive retirement accrues to the controlling interest
and none is apportioned to the noncontrolling interest (similar to downstream inventory or asset transfers).
As a result of the interest income and expense entries recorded annually by the companies involved, the constructive gain or loss is recognized over the
remaining term of the bond issue; accordingly, the total amount of the unrecognized gain or loss decreases each period and is fully amortized at the time the bond
matures. Thus, no permanent gain or loss is assigned to the debtor company’s shareholders.
Fully Adjusted Equity-Method Entries—20X1
In addition to recording the bond investment with entry (10A), Peerless records the following equity-method entries during 20X1 to account for its investment in
Special Foods stock:
(11A)
Investment in Special Foods Stock
40,000
Income from Special Foods
40,000
Record equity-method income: $50,000 × 0.80.
(12A)
Cash
24,000
Investment in Special Foods Stock
24,000
Record dividends from Special Foods: $30,000 × 0.80.
The full gain on constructive retirement is included in consolidated net income. That gain is attributed to the shareholders of the issuing company, Special Foods.
Therefore, Peerless records its proportionate share of the gain, $8,640 ($10,800 × 0.80), under the fully adjusted equity method.
(13A) Investment in Special Foods Stock
Income from Special Foods
8,640
8,640
Record Peerless’s 80% share of the gain on the constructive retirement of Special Foods’ bonds.
We note that a proportionate share of the gain is also assigned to the noncontrolling interest when the consolidation entries are made in preparing the worksheet. If
Peerless had been the issuing affiliate, all of the gain would have been included in its share of consolidated net income and none would have been allocated to the
noncontrolling interest. These entries result in a $264,640 balance in the investment account at the end of 20X1.
page 401
Consolidation Worksheet—20X1
Figure 8A–1 illustrates the consolidation worksheet prepared at the end of 20X1. The first two consolidation entries are the same as we prepared in Chapter 3 with
one minor exception. Although the analysis of the book value portion of the investment account is the same, in preparing the basic consolidation entry, we increase
the amounts in Peerless’s Income from Special Foods and Investment in Special Foods Stock accounts by Peerless’s share of the gain on bond retirement, $8,640
($10,800 × 0.80). We also increase the NCI in Net Income of Special Foods and NCI in Net Assets of Special Foods by the NCI share of the gain, $2,160 ($10,800 ×
0.20).
Special Foods’ bonds payable and Peerless’s investment in Special Foods’ bonds cannot appear in the consolidated balance sheet because the bond holdings
involve parties totally within the single economic entity. Note that the gain recognized on the constructive retirement of the bonds does not appear on the books of
either Peerless or Special Foods because the bonds are still outstanding from the perspective of the separate companies. From the viewpoint of the consolidated
entity, the bonds are retired at the end of 20X1, and a gain must be entered in the consolidation worksheet so that it appears in the consolidated income page 402
statement.
F I G U R E 8 A –1
December 31, 20X1, Consolidation Worksheet; Repurchase of Bonds at Less than Book Value
Thus, the consolidation worksheet entry to eliminate intercompany bond holdings eliminates the bond payable and its associated premium accounts from Special
Foods’ financial statements. It also removes the investment in Special Foods Bonds from Peerless’s financial statements. Finally, it records the bond page 403
retirement gain.
Eliminate Intercorporate Bond Holdings:
Bonds Payable
Premium on Bonds Payable
100,000
1,800
Investment in Special Foods Bonds
91,000
Gain on Bond Retirement
10,800
No consolidations are needed with respect to interest income or interest expense in preparing the consolidated statements for December 31, 20X1. Because
Peerless purchased the bonds at the end of the year, Peerless records no interest income until 20X2. The interest expense of $11,800 ($12,000 − $200) recorded by
Special Foods is viewed appropriately as interest expense of the consolidated entity because an unrelated party held the bonds during all of 20X1.
Consolidated Net Income—20X1
Consolidated net income of $200,800 (in Figure 8A–1) is computed and allocated as follows:
Peerless’s separate income
Special Foods’ net income
$140,000
$50,000
Gain on constructive retirement of bonds
10,800
Special Foods’ realized net income
60,800
Consolidated net income, 20X1
$200,800
Income to noncontrolling interest ($60,800 × 0.20)
(12,160)
Income to controlling interest
$188,640
Consolidated net income is $10,800 higher than it would have been had Peerless not purchased the bonds.
Noncontrolling Interest—December 31, 20X1
Total noncontrolling interest on December 31, 20X1, in the absence of a differential, includes a proportionate share of both the reported book value of Special Foods
and the gain on constructive bond retirement. The balance of the noncontrolling interest on December 31, 20X1, is computed as follows:
Book value of Special Foods’ net assets, December 31, 20X1:
Common stock
Retained earnings
Total reported book value
$200,000
120,000
$320,000
Gain on constructive retirement of bonds
Realized book value of Special Foods’ net assets
Noncontrolling stockholders’ share
Noncontrolling interest, in net assets December 31, 20X1
10,800
$330,800
×
0.20
$ 66,160
Bond Liability Entries—20X2
Special Foods records interest on its bonds during 20X2 with the following entries:
June 30, 20X2
(14A)
Interest Expense
Premium on Bonds Payable
5,900
100
Cash
6,000
Semiannual payment of interest.
December 31, 20X2
(15A)
Interest Expense
Premium on Bonds Payable
5,900
100
Cash
6,000
Semiannual payment of interest.
page 404
Bond Investment Entries—20X2
Peerless Products accounts for its investment in Special Foods’ bonds in the same way as if the bonds were those of a nonaffiliate. The $91,000 purchase price paid
by Peerless reflects a $9,000 ($100,000 − $91,000) discount from the par value of the bonds. This discount is amortized over the nine-year remaining term of the
bonds at $1,000 per year ($9,000 ÷ 9 years), or $500 per six-month interest payment period. Peerle